Why do individual investors persistently pour their money into actively managed portfolios, when studies demonstrate they would be better off putting it in an index fund? According to the Investment Company Institute, a U.S. mutual fund industry trade group, passively managed accounts encompass only 13 percent of assets in equity mutual funds, even though index funds have been around for nearly 40 years. Even institutional investors, with a greater appetite for indexed returns, only commit from one-third to half their holdings to passive portfolios.
Researchers have been wondering about this for years. Some chalk it up to slick marketing, tax considerations, a tendency to hold out for countercyclical performance, or other factors unrelated to performance. A new study by two academics, Robert F. Stambaugh of the Wharton School and Lubos Pastor of the University of Chicago Booth School of Business, is the latest to tackle this paradox. They conclude that there’s nothing irrational in investors’ preference for active management.
Instead, they are reacting to a problem that affects the entire asset management industry: decreasing returns to scale. “Any fund manager’s ability to outperform a passive benchmark declines as the industry’s size increases,” they write in a working paper first presented late last year. “As more money chases opportunities to outperform, prices are impacted and such opportunities become more elusive.”
The fewer active managers and investors piling into their portfolios, the greater chance that managers can detect and exploit mispricing situations that boost returns for their clients. That being the case, Stambaugh and Pastor say, investors don’t assume that it makes sense to pull all of their money out of active strategies when their managers go through a bad patch. Instead, they pull out part of their holdings – and wait for the field to empty sufficiently so that their managers can again find mispriced assets to exploit.
Stambaugh and Pastor studied active and passive portfolio returns stretching from 1962 to 2006. “What we found,” Stambaugh says, “is, rather than pulling all its money out when active managers underperform, a rational investor would probably behave exactly the way they do today – which is to collectively pull some of their money out, with the expectation that performance for the remainder will then go up.”
Stambaugh says that he and his co-author found that the “Nash equilibrium” – an element of game theory developed by mathematician John Forbes Nash, subject of the book and film A Beautiful Mind – applies to investors’ decisions. “Nash equilibrium” is a situation in which each one of a group of players knows the strategy all the others are following, and no one can benefit from switching if the others leave theirs unchanged. In the investment world, that means they will only change their strategy a little following losses: enough to give managers a better chance to exploit mispricing, but not enough to abandon what they still think can be a winning strategy.
“Ideally, I’d love everybody to take all their money out and put it in passively managed funds, so I can enjoy all the profits,” says Stambaugh. “But they’re not going to do that, so I will take out some of my holdings and leave the rest.”
Since investors make these moves based on their assessment of their entire active-management commitment, firms of all sizes and investment styles are equally affected, the researchers say.
What’s different about Stambaugh and Pastor’s analysis is that unlike most other researchers, they assume that alpha – return over and above risk – is not a constant figure. If investors believed that alpha is always the same, they would always have a clear signal when it makes sense to get out of the market. “In other words, if our rational investors thought returns to scale were constant,” Stambaugh and Pastor write, “the active management industry would have disappeared in 1969!” The fact that it didn’t suggests that investors change their alpha assumptions depending on the amount of money being invested by active managers.
Money managers themselves are sensitive to decreasing alpha. Terry Dennison, senior partner and director of consulting at Mercer LLC, notes that in 2007, “quant managers became concerned that they were participating in crowded trades. So they would sometimes move in one direction as a feint so they could then redeploy in a less crowded situation.”
But Dennison cautions that while investors may be aware when they have become part of a larger cohort chasing diminishing returns, other factors – some internal – also affect their relationships with active managers. “Often with institutional investors,” he says, “there’s an oversight body looking over their shoulder to make sure the portfolio doesn’t look too different from the market.”
That diminishes the opportunity to add value, he says, because it makes the investor less tolerant of tracking error or of strategies that deviate too far from the benchmark. “Money managers are profit-making businesses, operating on asset-based fees, and so they have an obvious incentive to maximize assets under management. That frequently requires dilution of some of their best ideas in order to enlarge their capacity to draw in assets.”
But even when investors look more deeply and critically at what their managers are doing, their reaction to changes in performance can still be explained as a logical response to a crowded market and the disappearance of mispricing, says Stambaugh: “Nothing in our model says investors act in a suboptimal way. We credit them with being fully smart and rational.”
