By Jason Zweig | Oct. 16, 2016 8:27 pm ET
Image credit: Umberto Boccioni, “Plasticity,” Museo del Novecento, Milan (Wikimedia Creative Commons)
Perhaps the least appreciated aspect of the rise of passive fund management and the decline of active is how shamelessly the active-management industry has contributed to its own collapse. Index funds would never have been able to become such an existential threat if stock pickers had run their own businesses more thoughtfully. I highlighted the shortcomings of the active-management business almost eighteen years ago in this guest essay I wrote for the great economist and investment consultant Peter Bernstein‘s newsletter. The response, at the time, was an outpouring of agreement from senior executives throughout the asset-management business — none of whom, so far as I could ever tell, did a thing about the problems they said I had diagnosed so clearly. Quite the opposite: Many of them went on to commit the same strategic blunders with more enthusiasm than ever.
A few excerpts:
Here, then, is one of the harshest truths of the information age: Cash flow from clients now rivals the investment process itself as the main determinant of total return. Thousands of retail investors, each wielding only a few thousand dollars, can smother a fund manager with cash as soon as they detect what appears to be outperformance. Alpha has always been perishable, but in today’s world of instantaneous information it is likely to have the shelf life of unrefrigerated fish. When a fund manager goes from absorbing a trickle of cash flow, to drinking from a fire hose, to surfing a tsunami, his past performance loses all relevance.
The time has come for investment managers to concede that, beyond a certain rate, asset growth is indistinguishable from suicide.
If he wants to excel, a manager must ignore tracking error and shatter the stylistic chains the middlemen want to shackle him in. But if he scoffs at tracking error in his quest for higher long-term returns, then he runs a much greater risk, at least in the short term, of underperforming somebody’s benchmark.
Since prevailing opinion is priced so rapidly into each popular stock as a form of public information, why go to the expense of forming your own opinion by gathering your own private information? It’s well-documented that birds behave this way, but now we are witnessing the sad spectacle of the smartest people in the world doing the same thing. When most information can no longer earn back the cost of gathering it, herding becomes the best short-cut to relative success.
Thus in today’s environment, in matters not one whit whether the market is efficient or not. If the tidal wave of short-term information has obliterated long-term thinking by managers and clients alike, if most managers are far too sheepish to capture any inefficiencies, and if they refuse to modulate the monstrous cash flows from their clients, then there can be no salvation for active management in the aggregate. Instead, managers must show the courage to shatter the system from within…. Otherwise, active management will remain what it has so sadly become: a deep out-of-the-money call option on hope — with no exercise date.
You can read it here: plbjz-copy.
Source: Economics and Portfolio Strategy (Peter L. Bernstein, Inc.), Feb. 1, 1999
