In a previous article, I focused on the decline of active management, arguing not that the potential for active management has declined over the past few decades, but that the practice of active management has declined. Put another way, empirical evidence demonstrated that the nature of the investment industry has changed immensely over the years, as an increasing number of assets became managed in a way that made it increasingly unlikely for so-called active investors to outperform.

Using active share as a proxy for the level of active management employed, recent data show that only about 20% of assets are managed by highly active managers (down from about 60% in 1980) and that nearly 50% of the assets are managed by managers with low to very low active share scores (up from about 2% in 1980). This represents a truly seismic shift in the way assets are managed, which leads to the question, How could this have happened?

Performance evaluation
Those who are fans of the hit show Breaking Bad will be familiar with the name “Heisenberg,” which is the pseudonym adopted by the main character Walter White—the unassuming high-school-chemistry-teacher-turned-criminal-mastermind. He took his name from Werner Heisenberg, a brilliant Nobel-winning theoretical physicist probably best known for his work on the Uncertainty Principle. The principle states—in very simplified terms—that the very act of measuring an item will change the very nature of the item being measured. His work was related to quantum particles, but I believe the same principle to be true in the investment world.

In considering the changing environment, two factors have been at play:

  • the introduction and wide acceptance of market index benchmarks for performance comparison purposes; and
  • as performance data became more readily obtainable, investors’ evaluation data points became more frequent and shorter term in nature.

These subtle changes have had a profound effect. Much like the Heisenberg principle, the frequent measurement and assessment of performance compared to benchmarks has changed the very nature of how money is managed. The focus of many investment firms started to shift from earning the best rate of return for a client—based on the client’s specific objectives and risk tolerance—to trying to beat an agreed-upon market benchmark. Frequent measurement, in turn, increased the probability of a truly active portfolio underperforming its benchmark at a given evaluation point, even though short-term performance is mostly market noise and has almost no relationship with investment skill.

As I’ve written about before (A tale of two funds: Assessing performance and Predictable underperformance), it can be demonstrated that the active managers who have exceptional records should be expected to underperform over the short- to mid-term and that no active manager is likely to outperform in all markets. Further, the magnitude of underperformance for top-performing long-term managers is likely to be much greater than most investors realize.

If you are a manager, managing to a benchmark, you will take a lot of business risk and potentially career risk if your performance deviates from the benchmark by too much or for too long.

An unfortunate but rational response from many managers was to implement portfolios in a way that would decrease their chance of looking “too dumb” at any point in the evaluation cycle. Thus, managers added more holdings and managed exposures closer to sector weights and/or geographic weights, and portfolios began to look more and more like the indexes they were supposedly designed to beat.

As noted, for investment managers, this was a rational business response to a business problem. John Maynard Keynes summed up the rationale nicely when he stated, “worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” What was good for reputation was also good for business; as long as your investment performance did not underperform by too much at any given point in time, then you would probably not be the first target for being fired.

By only failing their clients through a conventional level of underperformance, closet indexers preserved more relationships than those who failed unconventionally (even though short-term underperformance should not be considered failure) and thus closet indexing became the fastest growing area of investment management.

There was a pronounced shift in focus from long-term investment performance goals to a focus on not losing what legendary investor Seth Klarman has called “the short-term relative-performance derby.” Or, as noted economic consultant Charles Ellis has observed, “the business of finance (got) in the way of the finance profession.”

In this article I’ve explored some reasons for the shift to less “active” active management, focusing first on the investment management side of the equation. In the spirit of fairness, my next article will focus on investors and committees, and then I’ll look to offer some advice on how to move in a different direction.

Ryan Kuruliak is a Toronto-based vice-president with Proteus, an investment and governance specialty firm. He has more than 14 years experience in the pension and investment consulting industry.

These are the views of the author and not necessarily those of Benefits Canada.

Copyright © 2020 Transcontinental Media G.P. Originally published on

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