One of the funds we like to watch closely here at The Acquirer’s Multiple – Stock Screener is Dodge & Cox.
In 1930, in the midst of the Great Depression, Van Duyn Dodge and E. Morris Cox formed a partnership to provide investment counsel. Their confidence in this endeavor was fortified by Morrie Cox’s conviction that “well-conceived professional investment management could bring the force of some order into a rather chaotic investment world.”
The Dodge & Cox investment approach stresses evaluation of risk relative to opportunity. A strict price discipline — steering clear of popular choices that come at a price premium it would rather not pay. As of March 2017, Dodge & Cox had $63.4 Billion in assets under management.
Back in December of 2016 the firm released an article called, Understanding the Case for Active Management. It provides a solid case for the Active vs Passive Debate by focusing on a longer term prospective. The article highlights the six characteristics of successful active investors and states that many investors go astray by overreacting to short-term results and losing sight of their long-term investment horizon: They become too active in managing their active managers – its a must read for all investors.
While many active equity managers do not outperform the market in any given year, there are a number of skilled active investment managers who have outperformed over long investment horizons. However, in order to benefit from this kind of long-term outperformance, investors must be prepared to take a long-term view and have the discipline to withstand inevitable periods of underperformance. Those who stay the course are more likely to achieve meaningful incremental results that accumulate over time.
Academic and industry research has identified six attributes of active managers who have the highest probability of generating above-benchmark long-term results. This research has also confirmed that investors are well advised to take a long-term view, not only because few investors can accurately time the stock market, but also because few can effectively time their decisions to hire and fire investment managers.
THE ACTIVE VERSUS PASSIVE DEBATE
One of the fiercest ongoing debates in investing concerns the merits of active versus passive approaches to investing.
There has been substantial focus on the fact that a high percentage of active managers have underperformed their passively managed peers in recent years. But the case against active investing is not as clear cut as its critics suggest. There are, in fact, substantial opportunities for astute managers who take an active approach to outperform passive alternatives. While no active manager can beat all markets all the time, a significant number of active managers have outperformed over longer-term intervals.
The most frequently cited evidence against active management is that the majority of active managers fail to beat their benchmark each year. But that turns out to be flawed approach to measuring long-term investment performance. Evaluating and comparing results for a calendar year may be convenient but not necessarily meaningful. In fact, 12 months, and particularly the 12 months that start each January, is an interval that generally doesn’t encompass a complete market cycle, nor does it capture the success or failure of active management strategies, which tend to have longer investment horizons.
A value manager who adds a stock in January may still be waiting for the value he or she saw to be reflected in the market in December. Was the manager right or wrong?
It’s too soon to tell. Similarly, a growth stock manager may buy a stock in April, anticipating that the company is about to move onto a higher growth trajectory. The manager’s thesis may be right or wrong, but it won’t necessarily be proven by the end of that year.
The Long-Term Perspective
Let’s now shift the focus of the active versus passive debate to longer-term performance. According to Morningstar, 107 U.S. large-cap active equity funds have outperformed their benchmark over the past 20 years, out of a universe of 305 funds that have 20-year performance data.(a) These figures are flattered by the fact this universe only includes the funds that have survived 20 years.
The median outperformance by the 107 funds was 0.6 percentage points per year, with a high of 4.2 percentage points. Clearly outperformance is a game of inches, but because of the power of compounding, even modest outperformance can lead to substantial incremental returns over the long run.
It is telling that among those funds that have outperformed over the most recent 20-year period, when their respective results are divided into five calendar-year performance periods, the average fund outperformed in only 10 of the 16 five-year periods during the last 20 years. In short, over the long term certain active managers can add significant value, but that process involves an uneven road in which there will be years of sub-par performance as well as years of very good performance. Nonetheless, about a third of active managers described above beat the benchmark over the long term.
Passive investing advocates may protest: Who invests for 20 years? Answer: Many individuals, foundations, pensions, and other investors have investment horizons stretching 20 years and beyond. Foundations and endowments generally aspire to exist in perpetuity, so their investment horizon should be very long. Pension funds also typically have a long-term horizon; defined benefit plans may be taking in contributions for employees in their 20s to fund benefits that will not begin to be paid for as long as 40 years in the future, and then may last for another 30 years.
As for individual investors, many people, whether making personal investments or participating in a defined contribution retirement plan, have long-term investment goals. Because of increasing longevity, even investors in their 70s can often expect to live another 20 years. Of course, not all investors invest for the long term; those with short-term financial needs should consider their investment horizon in selecting the strategies and asset classes that best meet their needs.
Issues like immediate financial needs or simply a lack of patience may lead investors to take a shorter-term view—and that may also lead their managers to adopt a shorter-term view in order to please their clients. But taking the long view is critical when investing in equities; similarly, measuring active managers over the long term is the best way to discover which ones truly have stock-picking skill.
THE IMPORTANCE OF STAYING FOCUSED ON THE LONG TERM
… when you look beyond the 12-month horse race, there is potential to achieve positive long-term results by investing with a skilled active manager. However, after selecting such a manager, many investors go astray by overreacting to short-term results and losing sight of their long-term investment horizon: They become too active in managing their active managers.
Morningstar observed that because of poorly timed buy and sell decisions, over the ten years ending December 31, 2015, the average investor in U.S. diversified funds and international equity funds earned 0.7 and 1.2 percentage points less, respectively, per year than the average mutual fund’s published return. Many investors jump into funds after a period of good performance and rush out on the heels of bad returns. But these efforts to capture returns only hurt their overall investment results.
Another study, Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies, also found that the returns investors actually earned were much lower than the return they would have earned buying and holding their funds through the 22-year period under analysis. As shown in the chart above, this held true across all fund types. Over the last 20 years, mutual fund investors appear to have given up approximately 2% per year because of ill-timed buy and sell decisions.
The rewards of active management are more likely to accrue to those investors who are prepared to take a long-term view and stand by an active manager amid the market’s constant twists and turns.
There is good reason to believe that experienced and disciplined active managers have the potential to generate above-average returns. That performance differential can accumulate into substantial incremental gains over time. To achieve those gains, however, investors must be patient and persistent; they must have a long-term investment horizon and they must have the discipline to stick with an active manager and an active strategy through the inevitable periods of underperformance.
In order to choose an active manager with the highest probability of achieving outperformance, investors can turn to academic research that has identified six characteristics of active investment managers that are strongly linked to long-term outperformance:
- High active share
- Low fees and expenses
- Low turnover
- Risk avoidance
- Firm-wide focus on a core competency
- Close alignment of interests
These attributes can be recognized ex ante, and they are enduring. While reaping attractive investment results from active management is by no means a sure thing, there are fruitful ways to identify skilled active managers and benefit from their services.
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