One could argue that the active versus passive debate is poorly framed. While there is ample evidence to suggest that the average active manager underperforms net of fees, we believe “closet indexers” are primarily to blame for active manager underperformance. Perhaps a more productive discussion on the value of active management would be to analyze truly “active” managers versus “closet indexers.” We think that if you can find a way to differentiate between the two, the potential reward is significant.
In Dr. Martijn Cremers’s “Patient Capital Outperformance,1” he suggests there is a cohort of active managers who provide excess returns net of fees. He recommends selecting those with two essential characteristics 1) high Active Share and 2) long Fund Duration.2 In other words, an investor should select active managers who hold their stocks for longer than two years and build their portfolios based on conviction rather than benchmark weights. This approach results in tracking error and performance that deviates from indexes – but the payoff generates above-average performance results.
For example, after sorting approximately 1,200 U.S. equity mutual funds into four distinct portfolios, Dr. Cremers concluded that a $1 investment in the portfolio of high Active Share/long Fund Duration mutual funds would have outperformed a $1 investment in the portfolio of respective benchmarks over 40% between 1994 and 2015 in terms of cumulative excess net returns. The other three portfolios underperformed the benchmarks.3
While it may be tempting to run out and build a portfolio that looks nothing like the market and hold it for a long time, there are other factors to consider when selecting a manager. According to Dr. Cremers, “Successful managers need to have (i) the skill to identify good investment opportunities appropriate for their clients, (ii) the right judgment or willingness to choose among the identified opportunities in a prudent way, and finally (iii) sufficient opportunity or lack of practical obstacles to do so persistently.”4
Skill
Consistently high levels of talent and effort can fail to produce consistently good short-term investing results. Michael J. Mauboussin writes, “If an activity involves luck, then how well you do in the short run doesn’t tell you much about your skill. A good process is the surest path to success in the long run.5” At Harris, our competitive edge is identifying growing businesses managed to benefit shareholders. Our investment team undertakes a rigorous due diligence process, akin to a private equity manager, to reveal these businesses. We meet with management, competitors and suppliers to give us a vision into what the company will look like in five to seven years. Our analysts use these observations to project the future free cash flows, which ultimately determine business value. And we remain laser focused on business values, not stock prices: just because a stock is trading down doesn’t mean long-term fundamentals have deteriorated. Our process gives us a yardstick to measure discrepancies in value and empowers us to act. Our long-term success requires the discipline to stick to our investment process, even if it produces short-term losses. In the end, we expect to choose more stocks that go up than down, and the magnitude of our winners to exceed that of our losers.
Judgement
At Harris Associates, we believe that success in almost any endeavor requires having the freedom to think differently than others – and we strive to maintain an environment where our investment professionals trust our process. Our conclusions are formed from facts, and as a team, we openly debate them. We routinely conduct devil’s advocate analyses to ensure we have uncovered material risks. Our process provides confirmation that our judgement is sound, which helps us act, even when the crowd is running in the opposite direction.
As a result, we attempt to maximize our stock-picking skill by holding a focused number of stocks and weigh each one on conviction. Our portfolios range from 20 to 60 stocks and our most diversified portfolios have half the positions of our average competitor. Closet indexers do the opposite. They hold hundreds of stocks and mimic benchmark weights in an attempt to limit underperforming stocks. But the flip side is an inconvenient truth – closet indexers ensure their winners don’t have a significant impact either. After charging active fees for a benchmarked portfolio, there is little wonder why closet indexers underperform. Tracking error is deemed a risk to avoid, but in the end it’s outperformance that will be foregone.
Opportunity
Active managers must have the opportunity to stray from the benchmark. Dr. Cremers concludes that the more a portfolio’s weights differ from those in the benchmark, the more it works to outperform and justify management fees. At Harris, we populate portfolios based on conviction rather than benchmark weight, which can lead us to buy specific companies or areas of the market that are unloved, underappreciated or misunderstood. Periods of underperformance can follow as the gap between the stock price and intrinsic value closes. But, if necessary, we will gladly sacrifice short-term results as it has so often been the fuel for long-term success.
The United Kingdom’s referendum to leave the European Union last year highlights this time horizon trade-off. The first two days after the vote, the European stock index dropped approximately 15%, with certain European financial stocks dropping even more. We asserted that, as is often the case, the underlying intrinsic value of the corresponding businesses did not change as drastically as the market price. Our investment team tried to measure the true impact, if any, on the intrinsic value of the businesses we owned. We used this period to actively increase our exposure to companies, such as Lloyds Banking Group, that were hardest hit from the short-term fears. We believed the change in stock price was not reflective of the changes in underlying business value. Because of this discipline, embodied in our philosophy and process, our clients have benefitted from earning year-over-year returns. Though events like Brexit are often traumatic, they can provide opportunity for those who are patient.
It is equally important for investors to remain disciplined when invested in our strategies. Selecting managers based on typical industry barometers, like one-year performance or three-year rolling peer group ranking, may lead to inferior results. Dr. Cremers finds that “Patient strategies require stronger convictions because they are more risky for the manager to pursue. Short-term underperformance may jeopardize the manager’s ability to retain the assets and continue the long-term investment strategy.3” It may come as no surprise then that only 1.6% of total U.S. equity mutual fund assets are invested in strategies that are patient and have high Active Share.1 Harris is proud to be a member of this small cohort.
To illustrate this, the dotted green line in the following chart shows that our composites have had three distinct underperformance periods versus our peers: the dot-com bubble of the 1990s, the global financial crisis of the 2000s and the mid-2010s. However, when you switch to a longer term lens (the orange line), our investment process yielded long-term outperformance.
Long-Term Performance Consistently Ranks in Top Quartile Among Peers
Several finance professionals suggest that 25 years of data is needed to prove a skill’s existence. During the full 25-year period, despite the three periods of lagging our peers, U.S. Concentrated nearly doubled the return of the S&P 500 index since its first three-year performance number in 1994. However, some investors chose to go passive when our three-year performance number lagged. By chasing the market over the last 22 years, investors missed 300 percentage points in cumulative returns.
| 1/1/1994-12/31/2019 | U.S. Concentrated | S&P 500 Index | Chasing the market strategy |
|---|---|---|---|
| Annual return (CAGR) | 13.5% | 10.4% | 11.8% |
| Cumulative return (multiple of initial investment) | 40x | 18x | 25x |
*Hypothetical chasing the market strategy consists of three steps: 1) Client sells U.S. Concentrated whenever the trailing 3-year return lagged the S&P 500 Index 2) Client puts proceeds into the S&P 500 Index 3) Client invests again in U.S. Concentrated when the 3-year return exceeds the S&P 500 Index.
For highly active, disciplined investors who are willing to put in the effort and who don’t panic when times are tough, there’s as much opportunity as ever to outperform. By weeding out closet indexers and identifying managers with skill, judgement and opportunity over the long term, we believe fund selectors can still find tremendous value.
1Cremers, Dr. Martijn & Pareek, Ankur. (2014). “Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently.”
2Active Share is a calculation of the percentage of portfolio holdings that differs from the benchmark index. Fund duration measures the weighted-average length of time that the fund has held $1 of equities in the portfolio over the last five years. Cremers recommends investing with high conviction managers that hold their stocks longer than two years.
3Four mutual fund portfolios defined by the extremes in a 5×5 sort on Fund Duration and Active Share quintiles 1) long Fund Duration/high Active Share 2) short Fund Duration/low Active Share 3) long Fund Duration/low Active Share 4) short Fund Duration/ high Active Share.
4Cremers, Dr. Martijn. (2016). “Active Share and the Three Pillars of Active Management: Skill, Conviction and Opportunity.”
5Mauboussin, Michael J. (2012) The Succcess Equation: Untangling Skill and Luck in Business, Sports, and Investing. Boston, MA: Harvard Business Review Press.
Compound annual growth rate (CAGR) is the rate of return that would be required for an investment to grow from its beginning balance to its ending balance, assuming the profits were reinvested at the end of each year of the investment’s lifespan.
The S&P 500 Total Return Index is a market capitalization-weighted index of 500 large-capitalization stocks commonly used to represent the U.S. equity market. All returns reflect reinvested dividends and capital gains distributions. This index is unmanaged and investors cannot invest directly in this index.
The information, data, analyses, and opinions presented herein (including current investment themes, the portfolio managers’ research and investment process, and portfolio characteristics) are for informational purposes only and represent the investments and views of the portfolio managers and Harris Associates L.P. as of the date written and are subject to change and may change based on market and other conditions and without notice. This content is not a recommendation of or an offer to buy or sell a security and is not warranted to be correct, complete or accurate.
Certain comments herein are based on current expectations and are considered “forward-looking statements”. These forward looking statements reflect assumptions and analyses made by the portfolio managers and Harris Associates L.P. based on their experience and perception of historical trends, current conditions, expected future developments, and other factors they believe are relevant. Actual future results are subject to a number of investment and other risks and may prove to be different from expectations. Readers are cautioned not to place undue reliance on the forward-looking statements.
