For some reason, investors -- even institutional ones -- really like active management. Even though study after study shows that active strategies rarely outperform, and that the fees are generally enough to strip away any excess performance they can piece together, we flock to them like moths to flames.
What gives? And how do you fight the siren song of active management?
The first step is to understand the problem. In the end, you don't face exactly the same pressures as a professional investor, like competition for customers and the pressures of a career path, but you are subject to a lot of the same forces. By understanding what could be influencing your decisions, you'll better poised to make good ones.
"It's a bit like eating McDonalds -- I know it's bad for me, but still I eat it."
An Australian survey of pension fund chief investment officers (CIOs) and asset management consultants tries to get to the heart of the issue. The results (including the quote above) are fascinating.
It turns out that institutional investors seem to know that active management isn't usually justified, but they fall into step with it anyway.
The role of psychology
Money management is a competitive field, and there is an enormous amount of pressure to outperform in any way possible. To that end, most of the survey participants (over 70%) rationalize their allocation to active management by underlining their individual ability to select outperforming managers.
This could be a sign of overconfidence or just an awareness of what is required to compete with other managers -- one possibility is that you have to "look busy" to justify your fee.
Both overconfidence and looking busy are deeply applicable to the individual investing world. Overconfidence is a persistent problem for individual investors, as is the illusion of activity -- especially in this day and age, when sighing "I'm so busy" is practically a social requirement. Passive strategies, as the authors note, simply do not pay off in any other field of human or organizational endeavor.
And yet, in investment, they do.
The role of influence
Think of the amount of investment marketing you're subjected to as an individual, and now multiply that by some ridiculously large number and you can approximate the amount that your average CIO probably faces. Commanding a fair amount of money means that everyone wants a piece.
"I don't really know why I have so much [active management] when over 12 years they've added nothing," said one survey respondent.
Previous research has found that institutional investors are, as it happens, still human. They can be influenced by the way data is presented, by their own biases and quirks in understanding probabilities, and by advertising. While it's hard to tease out any one of these as a specific reason for choosing active management from a survey, the influences are definitely there.
The authors suggest that the issue might be revealed by a kind of "blame game" they identified, in which those surveyed tended to blame others in the organization for the extent of active management. It seems that even professionals are searching for justification.
The role of risk aversion
To be fair, it might not all be behavioral. While there is significant evidence of possible overconfidence and decision-making biases at work, survey participants also seem at pains to emphasize the rationality of their choices. One reason given for active management is to reduce risk: There is a belief that active managers will outperform on the downside.
There is some evidence that active management strategies outperform in down markets, even though they also underperform in rising markets. But this isn't an entirely air-tight case, and not all institutional investors would agree that active management provides additional downside protection.
However, you might also interpret this reasoning as a self-protective strategy: As a CIO or investment consultant, if you say that an active manager was "supposed to" outperform on the downside but didn't, you can justify the loss by saying the manager disappointed you. On the other hand, if you're in a passive strategy and perform just as badly as the market, there's no ready excuse to hang your hat on.
Do you use the same excuse?
How to fight it
This is all to say that investors -- institutional or otherwise -- tend to face a lot of pressures that, for better or worse, steer them toward active management.
So, how can you fight it?
The survey found that funds with "formal investment beliefs" had lower exposures to active managers, which the researchers take as evidence of greater discipline in decision-making. It makes sense: If you constrain your options through explicit criteria, it's easier to make choices that are in line with what you actually want.
This is something that any individual could apply to their own accounts. What is your investment philosophy? What is your strategy? What is your target allocation? From there, you can focus on the factors that are most important, whether it's fees, a particular sector, or a target allocation.
It's also important to step back and take marketing, influence, and psychology into account. If professional investors can be susceptible to these factors, you better believe that you are, too. Maybe you feel like passive strategies are too, well, passive to be any good, or you've been wooed by marketing and the promise of a better tomorrow. Perhaps you're very confident in your ability to choose better active managers than everyone else, or you just really enjoy the game of selection. Can you take a cold hard look at the truth in any of those beliefs?
It might just be to the long-term benefit of your portfolio.
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