The Rise and Fall of Performance Investing

Performance investing has enjoyed a remarkably long life cycle, but the costs of active investment are so high and the incremental returns so low that, for clients, the money game is no longer a game worth playing. Investors—both institutions and individuals—are increasingly shifting toward indexing. As acceptance of indexing grows, clients and managers have an opportunity to stop focusing on price discovery (which has made our markets so efficient) and refocus on values discovery, whereby investment professionals can help investors achieve good performance by structuring an appropriate, long-term investment program and staying with it.Performance or active investing began to flourish 50 years ago, has attracted large numbers of the best and the brightest as practitioners, and has spawned a remarkable range of innovations and changes in organizations, technologies, techniques, and information and in the way our capital markets operate. Many managers have prospered greatly. Few, if any, industries have rewarded so many so generously.However, as academic studies have proclaimed for many years and as the records show—after correcting for the distortions of deleting the records of failed funds and managers and ex post incorporating the records of newly discovered managers—active investment managers, as a group, have underperformed their chosen benchmarks.This underperformance is understandable. Fees are large and have been rising over the past half century as skillful, diligent, hardworking investment managers have made the markets increasingly efficient. Thus, most managers—particularly when only one-third of their portfolios are “active share,” which clearly differ from index funds—will be unable to absorb the costs of trading and fees and still achieve better-than-market rates of return. Underperformance after costs is not just understandable; it had to be expected as professional investors’ trading went from a small minority 50 years ago to an overwhelming majority today.Meanwhile, the compensation accruing to investment companies and investment managers has been generous for firms and individual practitioners, and so the investment business has been superb. But the investment profession centered on counseling—defining with the client the appropriate long-term objectives, risk constraints, liquidity needs, and market realities—has been allowed to atrophy. This reality is shown by the focus on “asset gathering” and “investment products,” with little or no attention to each client’s specific goals and objectives.Clients—both individual and institutional—have continued to be guided by subjective hopes and the assuring promises of active managers rather than by experiences or objective analysis of the relevant data.Gradually and persistently, however, investors have been shifting from active performance managers to indexing. The pace may appear slow, but it has been accelerating. Why has the pace of change been so slow? One reason is that so much of the “chatter” about investing—by managers, by consultants, and by the media—centers on winners and winning. Another reason is that major change is usually a social process with a few innovators leading, early adopters following, later adopters then coming along, and then even slow adopters and laggards coming too.Finally, each change goes through stages: awareness, deciding whether to change, and then making the change. Moreover, people can believe in almost anything when they are part of a group of people with the same belief. Despite the extensive evidence to the contrary, pension and endowment fund executives still believe that their active managers will outperform the market by a cool 100 bps.It is ironic that the skills of active managers have made it improbable that—other than by random chance—any specific active manager will outperform the market index for the outsiders (clients). This ironic reality has become the great test of our profession even as our business is achieving superior results for ourselves, the insiders. Are we putting our clients’ interests first? If not, are we a commercial business rather than a noble profession? Do we care?