In the Journal of Economic Perspectives, Malkiel writes,
The major inefficiency in financial markets today involves the market for investment advice, and poses the question of why investors continue to pay fees for asset management services that are so high. It is hard to think of any other service that is priced at such a high proportion of value.
After all, active management and fees have survived 40 years of efficient-market disdain. Economists who would dismiss “people are stupid” as an “explanation” for a pricing anomaly that lasts 40 years surely cannot use the same “explanation” for the persistence of active management. Economists who think the evidence favors lots of “inefficiencies” in the market are even less well placed to deplore active management. They should conclude that we need more, or at least better, active management to They should conclude that we need more, or at least better, active management to correct the market’s inefficiencies. Their puzzle is the inability of existing managers correct the market’s inefficiencies. Their puzzle is the inability of existing managers to pick low-hanging fruit. to pick low-hanging fruit.
I suppose that one can believe that there are a lot of inefficiencies in the market and also believe that active managers are so bad at finding these inefficiencies that they actually make things worse.
Anyway, read the whole essay.
Another way to look at this is to set aside the notion of efficiency, which tends to mean different things to different people, and just focus on the math.
Roughly speaking, when one investor deviates from a market capitalization-weighted portfolio (read: passive index fund), another investor has to hold the exact opposite active position with respect to the market cap weights. In other words, it’s a zero-sum game. Without considering fees, you would expect roughly half of the manager universe to outperform and half to underperform. After fees, you would expect most to underperform.
This is about what you find when you look at the data and smooth it out over a bunch of years to neutralize any systematic biases (e.g. differences between mutual fund managers and separate account managers or hedge funds or retail investors who may not be in your dataset).
In the long-only space, you’ll see maybe 60% of managers underperforming on average. It gets really ugly when you look at the 1940 Act (retail) “hedge fund” space, because of the higher fees. The last time I checked it was something like 80% or 90% underperforming on average.
And one more thing on the math – manager rankings tend to show little (or even negative) autocorrelation from one year to the next. Combine that with an expected relative return (after-fee return for active manager minus passive index return) that’s negative in any given year, and you except very few managers to cover their fees over longer periods of five or ten years. This, too, is borne out by the data.
Okay, I read the second paper (should have done this before commenting) and see that Cochrane did point out the math that Malkiel didn’t.
For what it’s worth, any results that I’ve seen showing the average active manager covering fees aren’t properly accounting for survivorship bias (this isn’t just an issue in the hedge & private equity space).
That said, Cochrane makes many excellent points and especially on the folly of trying to regulate inv. mgmt. fees.
“Roughly speaking, when one investor deviates from a market capitalization-weighted portfolio (read: passive index fund), another investor has to hold the exact opposite active position with respect to the market cap weights. In other words, it’s a zero-sum game. Without considering fees, you would expect roughly half of the manager universe to outperform and half to underperform. After fees, you would expect most to underperform.”
Not quite true. This assumes that all investing is done by investment managers. Since mutual funds only ever hold a fraction of the market- Malkiel pegs total assets of actively managed funds at $2.5 trillion in 2010, or about 15% of total US stock market value- what could happen is that retail investors get stuck in the lower half of the performance curve and investment managers stay mostly in the upper half, since they are so smart and professional. 😉 The fact that the vast majority don’t speaks to their lack of skill.
If I understand this correctly, it seems they make a basic economic calculation error by assuming that value of active management is only investment performance. When a high price persists against what one person thinks is low value, perhaps they should consider they don’t understand the value perception.
For example, some people pay the active management premium because they’d rather the pros be wrong than have to risk being wrong themselves. Also, there’s the lottery aspect. As the market shows, many folks are willing to take a chance to win big. Perhaps active management consumers are willing to take a chance that they’re investing with the next anomaly like Buffett.
Why is this surprising? People also buy clothes at double the price of other clothes that would serve the same functionality. The added value comes from having a choice, feeling different, making a decision, being part of a perceived group, etc. Financial products are no different.
My theory is that it not inefficient but that people are willing to pay for a chance to outperform the market. It is the same as the states lotteries everyone knows that they are a bad bet but they still buy the tickets because they like the idea that it is possible to win big.
I don’t know why anybody listens to Malkiel at all. His efficient market hypothesis is exploded regularly, and his corollary judgments like this suffer from the same flaw.
If you truly believe that everybody knows everything they need to know about a transparent market, then no guidance is necessary. If you believe that the market is inherently inefficient and downright dishonest, of course you’ll pay a guide to take you through it. This is not hard.