Several weeks ago a piece came out on Bloomberg that fit very much in their frequently used template of “academic research results – what it means and how it will effect you.” I find these stories irksome for the predictability of the strikethrough, but I’ll come back to that, because the research here was quite important, if not actually that new, and it matters for me and, I think, for savers.
The research in question dealt with the skewness of individual equity returns. I love skewness and its to-the-next-power brother, kurtosis. Indeed, the whole progression of return, standard deviation, skewness, and kurtosis always seemed to me to be a ladder that clearly separated the knowledge level and sophistication of any financial practitioner. The client rarely goes even so far as the second item on the list, but those doing the best thinking in the business seemed to inevitably be considering skewness and kurtosis even as return and standard deviation remained the statistics that got printed on the quarterly review.
Skewness highlights the lack of symmetry in the distribution of returns. We often use the Bell curve as our hypothetical example of how stock returns are distributed, but of course here we have already made a simplification (make it as simple as possible, but do no simplify!) for our clients’ benefit that does more harm than good. The average stock performs worse than the index, the research tells us. That is, positive skewness – the presence of a few incredible performers in the index – pulls up the average performance figures, even though an active manager will be more interested, or perhaps better to say more captive to, median performance. Quoting the doyen of smug grins and alternative indexing, Rob Arnott, the article states that with this in mind active managers are starting from behind the index, not even. With news that assets under management in passive products were larger those in active products for the first time ever as of the end of August, the research seems to be another death knell for active management. There was another article, months ago, citing recent research on active management that demonstrated how the presence of any kind of consistently alpha-generating active manager shrinks the opportunity set for others of the same kind, creating an ouroboros-like outcome where only a few elites manage to generate that performance consistently (and while the article doesn’t mention it, picking your winner of winners ahead of time must surely be an impossible task).
As the bell continues to toll for active management, I think less about fund flows and AUM than the actual work done in vain. Years and years ago I remember a very bright researcher publishing a report on the number of buy-side analysts and how the figure had ballooned in the past few decades. Anecdotally, in his career, Wall Street had gone from the repository of third sons to the hardest-charging, most lucrative (and therefore competitive) business in the country. Only now does technology, and perhaps the rarified world of private equity, start to take the hand off for this designation, but the damage is done. There are tens of thousands of professional analysts out there, be they fundamental or quantitative, and for every one employed by a D.E. Shaw or a Renaissance, there must be dozens at a firm that has added, after-fee, after-tax, precisely no value. Think of all the ink that has been spilled, the spreadsheets updated, the conference calls listened to, the footnotes reviewed, the presentations and pitch decks assembled, all to start behind the finish line and never ever catch up. It’s depressing twice over, in my mind, because not only has the analyst failed – all those years of work for naught – but the client is worse off as well! I haven’t put enough thought into it to see if the idea holds, but there’s a thought experiment in which all the assets from the bottom-performing, say, 25% of actively managed funds over the past decade had instead been invested in an index fund. Would that initial swap over have boosted the price at t-10, such that the whole exercise becomes recursive and self-defeating? Were the choices of those bottom 25% part of the process that led to their own underperformance or to the outperformance of the others? This is a question for Cliff Asness and Howard Marks, but given how the former has long since been trying to harvest premia and the latter’s deeply philosophical letters rather detract from the fact that at core he is buying junk bonds and other hard-to-value assets where the valuation and analysis are far more opaque, difficult, and therefore rewarding than the seasoned veteran trying to beat the S&P 500 using the tenets of Peter Lynch.
So much spilled ink, but to an extent so too is it spilled milk. I can complain about the inefficiencies and failings of this industry because it is the only one I know – I have no doubt elsewhere there are attorneys or doctors or civil servants similarly pulling their hair out in frustration. More to the point, the nit-picking about performance buries the lead on the fact that most people simply don’t have enough savings, or don’t have the ability to save. Even for those that can save, the importance of taxes and timing are critical – as I learned to my chagrin, the tax math is so critical that it more than wipes out any of the alpha analysts might spend so much time in pursuit of. The explosive growth of CFPs over the past several years is, I think, a partial acknowledgement of this fact (although equally an acknowledgement that, as paying for an advisor wasn’t producing outperformance, another value-add service was in order). And yet, as much as my foregoing complaint clearly affects the small percentage of the country who can save and invest enough, it seems to me the silent drift towards the management of taxes and liability management and retirement and all that is…sad. The romance is gone. If the investing world used to be the Age of Sail, with swashbuckling masters of the universe delivering untold treasure to a fortunate few, lots of risk, and high barriers to entry, today’s world is that off container ships slowly and predictably delivering containerized cargo along well-traveled roots. It’s better, but with the rough-edges shaven away, it simply isn’t as compelling for those of us who want to believe (likely mistakenly) that we can make an actual impact somewhere. Whether that means I end up doing something entirely different, or if I take a job checking boxes while the container ships disgorge their predictable cargo – glancing all the while at an old model of a tall ship in a bottle on my desk – remains to be seen.
smq.world 