Indexology^® Blog

Active management, success always?

As we discussed before, the success of active management is directly related to its outperformance of the benchmark it is comparing itself with.  In order to ensure consistency, active managers are reluctant to deviate from standards that include this comparison.  This leads them into situations where they may have to hold a position that may not necessarily be attractive to them, or there may be excessive movement of positions in the portfolio, resulting in additional costs and turnover.  Hence, a fund manager’s choice and conviction play a part in active strategy.  However, this being an individual choice brings in bias, which may work in certain market conditions and may not in others.

Another aspect to consistency is fund manager continuity.  Market participants get accustomed to a certain level of expertise provided to an active product by an expert fund manager.  However, change being the only constant results in movement of fund manager capabilities.  This may also disrupt the consistency of the investment product in following particular return patterns.

For those looking for a certain return trajectory, passive investing may be the preferred solution.  This also applies to those who are not vigilant on the consistency of fund manager or product continuity, or who are not able to track the market conditions on a day-to-day basis.

Say a market participant who wants to invest in the manufacturing sector can easily buy into a product based on a manufacturing index.  This enables consistent and relatively cheap access to the sector.  Furthermore, there are a wide range of choices beyond sectors.  Factors offer the option to invest in stocks via the factors that may be preferred.  Passive investments offer a host of factors, such as growth, value, dividend, low volatility, momentum, etc.

In this evolving paradigm, with market participants growing more savvy and passive investments offering a host of options, the opportunities this space offers is definitely growing.

A famous quote by Mark Twain stated, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”  So can we state for sure that active management is superior? Maybe we should give it a bit of thought!

3 billion people entering the middle class¹ and $30 trillion of annual consumption by 2025² – these are two numbers that summarize the drastic demographic and economic shift currently happening in emerging market countries and what McKinsey & Co. has called, “the biggest growth opportunity in the history of capitalism.²” The Dow Jones Emerging Markets Consumer Titans 30 Index is comprised of 30 of the largest and most liquid emerging market consumer companies that are poised to benefit from these changes.

Consistent Outperformance
The emerging market consumer is not a new theme and since the inception of the Dow Jones Emerging Markets Consumer Titans 30 Index (1/8/2010), these companies have outperformed broader EM indices. Over 3 year rolling return periods (rolled monthly), the Dow Jones Emerging Markets Consumer Titans 30 Index has consistently outperformed both the MSCI EM Index and the S&P Emerging BMI Index under almost all market conditions. As seen in Figure 1:

• The Dow Jones Emerging Markets Consumer Titans 30 Index has outperformed the MSCI EM Index 94% of the time.

• The Dow Jones Emerging Markets Consumer Titans 30 Index has outperformed the S&P Emerging BMI Index 85% of the time.

Is the best yet to come?
The historical performance of the Dow Jones Emerging Markets Consumer Titans 30 Index has been impressive, but the growth of the emerging market consumer is in its infancy. As seen in Figure 2, the emerging markets middle class is estimated to represent 15% of the world’s population in 2030, up from 4% in the year 2000.

The Takeaway
There is no denying demographics – emerging market populations will continue to grow rapidly and the emerging market consumers will continue to increase their wealth. However, broad emerging market benchmarks do not target this exposure, as the consumer sectors make up less than 20% of those benchmarks.

By specifically targeting consumer-oriented companies in emerging markets, the Dow Jones Emerging Markets Consumer Titans 30 Index has generally been able to outperform broad market indices since its inception. More importantly however, this index taps into the future growth of the emerging market middle class, which looks brighter than ever.

For more information on this topic, watch the replay of S&P Dow Jones Indices’ webinar, “Painting Emerging Markets with a Narrower Brush.”

¹Ernst & Young, “Innovating for the next three billion”, 2011

² McKinsey, August 2012, “Winning the $30 trillion Decathlon”

The posts on this blog are opinions, not advice. It is not possible to invest directly in an index.

There are many extraordinarily talented minds engineering optimal portfolios, objectives of which include maximizing return per unit of risk, among others.  The capital asset pricing model (CAPM) posited the market portfolio as optimal in the mean/variance sense, but over the years, this notion has been questioned.  CAPM, like the efficient markets hypothesis (EMH), will likely be deliberated for a long time to come.

A more intuitive approach to the market portfolio may be easier to digest and lead to improved market participant behavior, and a couple of self-evident, market-related facts can lay the foundation of such an approach.  First, all stocks must be owned by someone, and in the aggregate, all market participants’ shareholdings form the actual market portfolio.  Second, the actual market portfolio must be cap-weighted.  Third, broad cap-weighted equity indices provide a scale model of the actual market portfolio—not perfect in every detail, but close to the real thing—and anyone seeking to closely replicate, on a smaller scale, the actual market portfolio may do so by buying shares in an index fund.

Of course, the CAPM has contributed much to the body of financial knowledge, but market experience seems to collide with theory, because it seems apparent that the market portfolio is not necessarily optimal.  My gut-level explanation is that, because the actual market portfolio is the aggregate of all market participants’ shareholdings, it is also the sum of all investment strategies.  In other words, it is the aggregation of all stocks, factor exposures, styles, sectors, industries, and strategies.  How can it be optimal in any given period, when there will always be segments of it that do better (i.e., are more mean/variance optimal) than others?  This question leads to my hypotheses that 1) the case for indexing does not rely upon CAPM (or EMH for that matter, but that’s a story for another day) and 2) the real case for indexing is that, with appropriate capital management (i.e., not accepting too much or too little market risk), it may minimize the pain of regret.

Since the market is the living aggregation of all strategies, one cannot be long a strategy (a subset of the market) without simultaneously being short another (a different subset of the market).  For example, if you weigh a portfolio of stocks by a fundamental measure like revenue, you’re long revenue production relative to the market but you’re short other measures.  In this case, perhaps you would be short growth, because the largest revenue producers probably are not the fastest growers.  The tricky thing is that it’s hard to observe what you’re actually betting on and shorting when you select strategies, which can lead to regret if subsequent performance turns out to be disadvantageous relative to the market.  Even if you have perfect transparency into the factors you’re betting for and against, you still have the challenge of timing them—which, if you’re wrong, can also lead to the pain of regret.  After all, it is quite easy to get the market return, but it is pretty painful when the active manager or strategy that you have put many hours of research into underperforms.  What could be more regrettable in the investment world than that?

In grid-iron football, The Red Zone refers to the area between the 25 yard line and the goal line, the last remaining ground the offense must battle through in order to score a touchdown.  This is a somewhat apt metaphor for what we’re currently witnessing with the Dow Jones Industrial Average.

Unless you’ve been living under a rock these last few weeks, you are no doubt aware that The Dow has been closing in on, yet remaining tantalizingly short of, the 20,000 level.  Coming as close as a mere .37 points during the Friday, January 6 session, as of this writing the DJIA has yet to record its first close past this vaunted milestone.

Investors and the market commentariat have been teased with the event for days, but the 20k level has thus far remained resistant to breach.  More specifically, it’s the last 100 points – the distance from 19,900 to 20,000 – that has proven to be such stubborn ground to cover.  Why?  Even if I could, I won’t answer that here – better-informed market participants can speak into that analysis.  But I can say that the DJIA’s current Red Zone campaign just became the most protracted of recent major milestones.

Listed in the table below is the number of trading days it took the DJIA to move through that last 100 points leading up to round, 1,000 point increments.  As of today’s close, which was again found wanting, we find ourselves 19 days into this journey.  Thus, even if we hit our target tomorrow, it will have taken the DJIA 20 sessions to cover the last 100 points – longer than the ten 1,000 point campaigns that preceded it.  On average, it has taken less than 7 trading sessions to cover that distance during recent memory.

How much longer?  As William Faulkner said, “And sure enough even waiting will end…if you can just wait long enough.”  A quote from Vince Lombardi might be more appropriate here but, hey, this was the best I could find.

Indexing is certainly not a myth, and while active investing is a popular reality in Indian markets, we are seeing the slow and steady rise of indexed products.  In a recent article, John C. Bogle, the founder of Vanguard Group, said, “We are in the middle of a revolution led by indexing.”[1]  John C. Bogle’s first index fund was launched in 1976, and Vanguard is among today’s top global ETF providers.

Revolution indeed; when we see the global ETF assets at over USD 3 trillion, there is no doubt that this space has seen exponential growth.  However, there is no argument against the fact that active management can be successful.  Advocates of active management argue the ability to outperform benchmarks is what supports their claim on the supremacy of the active play.

However, the question is not whether active management is successful, but rather for how long it is persistently successful.  So first, let’s review the outperformance of benchmarks.  This brings us to review whether the appropriate benchmark is being followed.  “Appropriate” is an important qualifier—among other things, it means that the benchmark should be consistent with the manager’s portfolio selection style.  To explain this further, a thematic investment portfolio (e.g., for a dividend fund) should ideally be compared to a dividend index rather than a generic market benchmark like the S&P BSE SENSEX or the S&P BSE 200.  This ensures that there is an apples-to-apples comparison.  This also ensures that market participants are comparing similar universes; hence the “appropriate” comparison.

In the passive world, since the market participants own a proportionate slice of the index, they are earning the index returns less fees and expenses.  In other words, the investment and its objective are aligned directly with the index.  There should be no subjectivity or doubt as to how the index and its benchmark are aligned.

Hence, the first step to ensure that we are measuring active performance appropriately is to check if the investment strategy or product is appropriately benchmarked.  That then provides us with the “real” picture.

[1]   ET, Bloomberg, Nov. 25, 2016.