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The case against active management is not that nobody ever beats the market. It’s that they do not do so reliably, predictably, or systematically.
In 2006, the Canada Pension Plan Investment Board announced it had switched from a “passive” to “active” investment strategy. No longer would it merely seek to replicate the performance of the broad equity and bond market indexes in its own portfolio, as it had earlier been required to do; now it would free its managers to pick and choose, buying and selling at particular times in an effort to “beat the market.”
In pursuit of its new mandate, the fund has undergone a massive expansion in staffing, compensation, and costs. The number of employees has gone from 164 in the year ended March 31, 2006, to 1,661 in fiscal 2019. Total costs have grown from $118 million to $3.3 billion annually, or from 0.12 per cent of assets to 0.83 per cent. All told, the fund has spent about $22 billion over the past 13 years, or more than six times as much as if it had kept spending the same amount, in proportion to assets, as it did in 2006.
What a relief to find it was all worth it! Or so claims the Parliamentary Budget Office in a new report. Having set out to determine “whether [the CPPIB’s] active management strategy resulted in higher returns compared to a passive strategy,” the PBO finds that, indeed, the fund’s annual returns under active management were 1.2 per cent higher, on average, than they would have been under passive, contributing an extra $48 billion, in total, to the fund’s holdings.
This is an extraordinary finding. The CPPIB itself, not known for keeping its light under a bushel (along with everything else, the length of the fund’s annual report has ballooned, from 25,000 words in 2006 to 90,000 words in this year’s doorstopper), does not make this claim. Its 2019 annual report estimates the fund’s $392 billion portfolio is $29 billion larger than it would have been had it stuck with passive management. On average, it claims to have beaten the market — measured by a “reference portfolio” of stock and bond indexes — by just 0.6 per cent annually.
What explains the discrepancy? One part of it seems to be the asset mix the PBO chose for its benchmark. The CPPIB doesn’t just invest in the public markets. Much of its portfolio is in more esoteric, less frequently traded assets whose values are harder to assess: private equity, real estate, public infrastructure projects and so on. There’s general agreement that it’s significantly riskier than a portfolio with a comparable mix of debt and equity, but made up entirely of publicly traded assets.
That’s important because, other things being equal, a riskier portfolio would be expected to perform better than a safer one. (Riskier assets have to pay better, to induce people to hold them. Or to put the matter another way, if you want to do better than the market average, you have to take on more than average risk.) If the CPPIB were to consistently earn a higher return than a benchmark of equivalent riskiness, it would have something to brag about. But outperforming a safer portfolio might well be underperforming, on a risk-adjusted basis.
Will it still be ahead of the game 13 years from now?
So while the CPPIB nominally holds just 56 per cent of its portfolio in equities, for comparability its benchmark would have to hold a much higher proportion of equities. The fund itself has belatedly admitted this: its reference portfolio is now made up of 85 per cent equities, up from just 65 per cent in 2015. And yet the PBO’s “baseline” case, the source of its claimed 1.2 per cent annual premium for active management, is measured against a passively managed portfolio with 70 per cent equities. At 85 per cent, the claimed gains dwindle to 0.6 per cent.
Worse is the PBO’s treatment of costs. The return that matters, as any mutual fund investor knows, is not the gross return but the return net of costs: one of the reasons actively managed funds tend to underperform passively managed is because their costs are so much higher. Bizarrely, while the PBO study deducts transaction costs and management fees — which are now, respectively, 17 times and 44 times what they were under passive management — from the CPPIB’s returns, “operating expenses were assumed to be the same under either approach.”
But this is absurd. Operating costs, at $1.2 billion, are now 22 times what they were in 2006 — five times as much, relative to assets. Assuming instead that they were the same as under passive management would greatly overstate the CPPIB’s net returns, and exaggerate any premium to active management.
But leave that aside. Even if the PBO study had not used an unrepresentably safe benchmark, and even if had not understated the CPPIB’s costs — even, that is, if the CPPIB had actually beaten the market by the amount claimed — it still wouldn’t make the case that this outperformance “resulted” from the switch to active management, still less prove that active management is superior.
Suppose, as an alternative scenario, the CPPIB’s managers had bet the fund on the fifth race at Woodbine, and suppose their their horse had won. It wouldn’t mean either that betting on the horses was a good investment, or that the CPPIB knew how to pick horses. It would just mean they got lucky.
The case against active management, amply supported in the research — at least two-thirds of investment managers in any given year underperform the relevant benchmark — is not that nobody ever beats the market. It’s that they do not do so reliably, predictably, or systematically. Probability theory teaches us that, if you toss a coin 10 times, it should most often come up heads five times, tails the other five. But it’s entirely possible for it to come up heads 10 times in a row, without discrediting probability theory.
The CPPIB has bet billions of dollars over the past 13 years on the proposition that it can consistently beat the market. It’s possible that it has, so far. Will it still be ahead of the game 13 years from now? We shall see. But by then the money will have been spent, and the managers paid, and it will be too late to ask for it back.
Copyright Postmedia Network Inc., 2019