Despite recent speculation over “the end of active management as we know it,” L2 Asset Management co-founders Matt Malgari and Sanjeev Bhojraj argue in a recent blog post on Advisor Perspectives that the reports of active management’s death are greatly exaggerated. Malgari and Bhojraj argue that it’s quite easy to beat the market over the long term.
An investment philosophy anchored in behavioral finance, defined by quantitative data, and refined by fundamental analysis mitigates the behavioral errors that are unintentionally committed and exacerbated by blindly the following indexing. Adherents to indexing are accidentally engaging in performance chasing or herding, which is a common and costly behavioral error.
Passive management proponents accept the inevitability of buying stocks of money-losing companies because they believe it impossible to separate the winners from the losers. The benefit of eliminating the negative earners is indisputable. A single factor strategy of not buying money-losing stocks soundly beats the index over time. The percentage of money-losing firms in the Russell 2500 is near all-time highs of approximately 35%.
Malgari and Bhojraj ask why buy an index filled with these negative earners when the history of these stocks demonstrates they will likely underperform the positive earners? The record weight of loss-making stocks in the index today could prove a more formidable headwind going forward.
From December 31, 2016, to April 30, 2022, a speculative bubble in negative earners caused them to outperform positive earning firms for most of that period. The stock price of those negative earners started to decline from its peak in June 2021. History provides powerful evidence that this trend lower for loss-making stocks will likely continue.
While separating positive and negative earners is likely to beat the index in the future, there’s another factor that supports the case for smart active management: as of April 30, 2022, negative earning stocks have a total yield of -6.4% vs. 2.8% for positive earners. So, why buy an index that includes a record number of negative earners at very high valuations?
According to Malgari and Bhojraj, blind adherence to a passive strategy is not “low cost,” but quite costly to investors. For every dollar invested in the Russell 2500 index from December 31, 1978 to April 30, 2022, investors earned $161 compounded. By separating negative from positive earners, they would have earned $227 compounded. Following a passive strategy cost those investors $66 for every dollar they invested.
The dogma surrounding indexing also obscures the goal of avoiding regulatory risk. Investors are not well-served by being herded into passive funds that include significant exposure to stocks with weak fundamental characteristics and elevated valuations.
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