ACTIVE MANAGEMENT: A PREMATURE EULOGY
“They moved off slowly with bowed heads, like a couple of pallbearers who have forgotten their coffin and had to go back for it.” —P.G. Wodehouse
Early last month, I attended an alumni reunion for the University of Wisconsin’s Applied Security Analysis Program. While Madison isn’t exactly a hotbed of global finance and lacks the reputational cachet of the Ivy League, the Hawk Center has produced an inordinately high number of successful investors, many of whom are household names.
While there, I attended a panel entitled The Future of Asset Management. The moderator began by asking if a better question might be “does it even have a future?” A fair comment, but I suspect his prospects as a motivational speaker are limited.
You see, the rise of passive ETFs hasn’t been kind to active management. The program’s most successful alumni graduated in the 1980s, when asset management was still in its infancy. In 1982, total assets in mutual funds were just $66 billion (versus $21 trillion today). Discount brokerages had begun democratizing equity ownership and the newly created 401(k) industry stoked demand for new products. In the interim, the S&P 500 rose 15-fold. That’s a tough act to follow.
Today’s aspiring analyst faces a different reality. Persistent redemption, chronic short-termism and unrelenting fee pressure have led many to fear the industry’s best days are behind it. Among equity funds, passive inflows have exceeded active for the past 18 (soon to be 19) years. It took three decades, but last year passive assets eclipsed active for the first time ever. Investors are voting with their wallets and it’s clear they prefer passive.
Since index funds just buy all the stocks, they have little need for stock pickers. Every time an investor opts for a low-cost ETF instead of a high-priced fund, a security analyst loses his wings. Much of the active industry is in redemption, relying on market appreciation just to stand still. Turns out it’s hard to compete with free.
Don’t worry, I’m not here to rehash the passive/active debate and as an active manager, I’m clearly biased. Low fees and a return no worse than average hold obvious appeal. But I’ve heard it said that it’s impossible for active management to add value, a statement I’m compelled to correct.
“90% OF MANAGERS FAIL TO KEEP UP WITH THEIR BENCHMARK.”
This oft repeated statistic is currently true, but only of large cap mutual funds (of which I am neither). According to Morningstar’s Active/Passive Barometer, fewer than 10% of large-cap mutual funds have earned their fee over the past 15 years. It’s important to realize that this statistic waxes and wanes. When measured over the past five years, the success rate improves to a somewhat less disappointing 35%.
But cause matters more than effect. Passive buyers assume this underperformance stems from fees, but the real culprit is the ascendency of the Magnificent Seven (think Apple, Nvidia, Microsoft, Amazon, Meta, Google and Tesla). Because of SEC rules, any fund that markets itself as diversified must underweight them. Because of their outsized performance, this has created a persistent performance drag.
Saying active management can’t add value is akin to saying every doctor’s patient dies eventually. It’s more accurate to say that large cap mutual funds aren’t adding value right now. Historically, periods of extreme concentration in just a few securities have not ended well. I have no idea when this will change, only that it will, and investors may view active management differently when it does.
I should also point out that I chose to specialize in small and midcap stocks because I believe that’s where active management is most likely to succeed. Because the universe is large and can absorb finite capital, it’s far less efficient. Due to capacity constraints, many funds overdiversify to absorb capital, diluting their best ideas.
While there are obvious costs to founding your own firm, it has one significant benefit: you get to decide how it’s run. Some will try to please consultants, making frequent concessions to gather assets and become more institutionally palatable. Do this long enough and eventually you’ll look like the market.
I’m taking the opposite approach. I designed Epigram Capital to preserve what’s best about active management: conviction, opportunism and differentiation. These are the three things passive can’t offer and no one has ever outperformed without them.
Sincerely,
Dan Walker
General Manager
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DISCLOSURE
This material is confidential and may not be distributed or reproduced in whole or in part without the express written consent of Epigram Capital, LLC (the “Investment Manager”). This material is not intended to provide, and should not be relied on for, investment, tax, legal, or accounting advice. You should consult your own investment, tax, legal, and accounting advisers before engaging in any investment transaction. The information and opinions contained in this document are for background purposes only and do not purport to be full or complete. No representation, warranty, or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained in this document, and no liability is accepted as to the accuracy or completeness of any such information or opinions.
PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
This material may contain certain forward-looking statements and projections regarding market trends, investment strategy, and the future asset allocation of the Fund, including indicative guidelines regarding position limits, exposures, position sizing, diversification, and other indications regarding the Fund’s strategy. These projections and guidelines are included for illustrative purposes only, are inherently predictive, speculative, and involve risk and uncertainty because they relate to events and depend on circumstances that will occur in the future. The guidelines included herein do not reflect strict rules or limitations on the Fund’s investment program and the Fund may deviate from the guidelines described herein. There are a number of factors that could cause actual events and developments to differ materially from those expressed or implied by these forward-looking statements, projections, and guidelines, and no assurances can be given that the forward-looking statements in this document will be realized or followed, as described. These forward-looking statements will not necessarily be updated in the future.