“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
Betty Crocker introduced Hamburger Helper in 1971. You took chopped meat and added it to the eponymous mixture of macaroni* and spices. In essence, you took the good stuff, the ground round, and added filler to stretch out the meal. Much of active management works the same way.
Randy Cohen, Christopher Polk, and Bernhard Silli published Best Ideas in 2009. They found that mutual fund managers’ favorite pick tended to outperform its US stock benchmark by 1-4% per quarter, depending upon the benchmark. They also discovered that around five or so of the managers’ “best ideas” did better than the chosen index. The problem is that the managers did not stop there. They held about 90 more stocks, on average per year, over the 1990-2005 time frame of the study. Those 90 stocks usually did not contribute to the managers’ performance versus the benchmark. They were filler, Hamburger Helper.
Best Ideas suggests that investors would be better off with a large number of small undiversified “best ideas” portfolios comprising their overall portfolio. Good luck explaining that, getting people to buy in and, not least, identifying enough skilled managers (ex ante) who are willing to run such portfolios.
What is really going on, despite their desire to outperform, is managers’ response to the other incentives dictating their behavior.
- There is career risk, the risk that they will lose their jobs if their performance doesn’t stack up over a one, three or five year horizon. They hedge against career risk by diversifying.
- There is business risk, the risk that poor performance undermines their business or the business of their employer. Once again, diversify.
- There is volatility risk, the risk that their portfolio fluctuates a lot. Volatility is the enemy of building and maintaining assets under management. Why scare away investors or chance a lawsuit? Diversification is not just for investors.
These phenomena lead inevitably to portfolios that, in spirit, resemble Betty Crocker meals from the 1970s. The excess performance from the manager’s best picks are soaked up by the fee and then some. Poor performance results.
Keynes was right; it’s better to fail conventionally.
If the skill of equity managers — and Cohen et alia did show that there is skill — is swamped by Hamburger Helper there is no reason to pay elevated fees for active management. This is why assets are draining away from traditional active management and flowing to index funds and ETFs.
The flow into lower priced index funds and ETFs has created the potential for better outcomes. Unbundling market exposure from products or strategies that have a better chance of adding to market returns allows investors to pay low fees for mere market exposure while reserving premium fees for products or strategies that could outperform.
If you’re going to buy Hamburger Helper, you might as well pay the right price for it.
* Trust me, in 1971 no one called it pasta.