Bloomberg Markets’ Carol Massar Asks OSAM:
Active or Passive?
Last week was the 8-year anniversary of The Great Recession’s March 9, 2009 market bottom. To celebrate, or whatever you’re supposed to do to commemorate low points, we offer the first in a series of recent interviews with the OSAM Research Team. Honestly, even if this conversation happened the next day, March 10, 2009, the tenor would’ve been about the same: If your formula works, stick to it.
“O’Shaughnessy on Active vs. Passive”
Bloomberg Markets transcript1
(Bloomberg Radio, Thursday 4:10 pm, Feb. 2, 2017)
Carol Massar2 (BBR):This is Bloomberg Markets. I want to bring back our guest Jim O’Shaughnessy, Chairman, CEO, and Chief Investment Officer at O’Shaughnessy Asset Management, based in Stamford, Connecticut — in our Bloomberg AM 1130 radio studio. I want to talk “active versus passive” but somebody tweeted out, ‘Highest corporate tax rate but very few companies pay that rate,” which is true …
Jim O’Shaughnessy (Jim): True.
BBR: It’s actually below 25%. So, how does lowering the rate help?
Jim: I think if they get it down to under 20, it would help a lot with repatriating a lot of cash.
BBR: It would make a difference.
Jim: I think so. Yeah.
BBR: Alright I want to talk “active versus passive” because you’ve been looking at this, and it has been a subject of something we’ve been talking a lot about at Bloomberg, and that this whole idea that maybe active management just doesn’t work anymore?
Jim: So, I think active management still works. However, I have come to the conclusion — after 30 years of doing this and seeing clients’ behavior just continue to repeat itself — that I believe that the majority of investors lack the emotional characteristics and the personality traits that allow them to go on to become successful investors.
BBR: Meaning, they’re reactionary?
Jim: Yes. Therefore, I’ve come to the conclusion that to do the best over time — let’s say, saving for retirement — the majority of investors should go completely passive. Because if they go completely passive, they really only have 1 point of failure, assuming they have a well-diversified portfolio, on the equity side and on the bond side. That point of failure is panicking near a market low, and selling out. Active investors have 2 points of failure; the first is the same as passive investors (panicking and selling out) but the second is one we see happen much more often, and that is —
Jim: Chasing. And, firing a manager who’s underperforming, sometimes over as little as 3 years, even if they’re getting positive returns, right? So they earn 10% over the previous 3 years, the benchmark earns 12%, and they say “Oh this is awful, I’m going to fire that manager.” Well, guess what. A study you can find at my friend Josh Brown’s The Reformed Broker3 found that the managers you fire, on the active side, go on to outperform the managers you hire.
BBR: Really? What’s the thinking about that?
Jim: Well, regression of the mean … and so, what I think is that the minority of investors who possess the right kind of personality traits, can do very well with active management, but that many people really just don’t have those traits. We can blame evolution, right? Evolution has us focusing on what is happening right now.
BBR: It’s like being a teenager: It’s all about “right now”.
Jim: Exactly. Our ancient ancestors, right? Who did we get the genes from? The one who saw the bush rustling and ran away? Or the one who just said, “Aw, that’s nothing.” We got it from the one who ran away! Because a lot of times it was a tiger, and the other guy died, and his gene pool didn’t go on. So that’s created within us this idea that we vastly overweight what’s happening right now, as opposed to the very long term. Cliff Asness, the co-founder of AQR, had a great quote, which was basically along the lines of, “Having, and sticking to, a true long-term perspective is the closest you’re gonna get to possessing an Investor Superpower.” And my belief is, most don’t have that.
BBR: But what about underperformance in a world where there are still some fees? Like, why would you do that?
Jim: Well that gets to my next point.
BBR: Even if you say longer-term …
Jim: Well that gets to my next point. Which is, for people who are going to succeed as active investors, the process is much more important to them than the outcome. Right? And by that I mean, they want to understand the process that led to the performance. Is it a good process? Is it a bad process? If it’s a good one and it leads temporarily to a bad result, they’re going to maybe be able to understand, “You know what? Let’s look at the longer-term record of this particular manager.” And when they look at the longer term, they might see a fantastic long-term return.
Every active manager is going to underperform for certain periods of time. And the one I highlighted as having a process — one person who was familiar with what I was writing — said, “Well, Jim, you’re a quant. Of course everything is process!” But then I got to thinking about it and I thought, “Well, Warren Buffett, Charlie Munger — right? — Berkshire Hathaway; they have a very delineated process. They want recognizable brands that have wide moats. They want simple, easy-to-understand products. They want consistent, solid earnings gains. They want low debt. They want good return on equity. This is their checklist, right? If they don’t find it, they don’t buy.
And yet, if you were approaching Berkshire Hathaway — and by the way, $10,000 invested in Berkshire Hathaway Class A at the beginning of 1977 grew to $27.4 million.
BBR: I know, it’s crazy.
Jim: The same $10,000 in the S&P was $208 — yet, if you were one of those guys who fired somebody for underperformance, in 1999, Buffett’s stock was 7.6% worse than the S&P for the previous 3 years; 3.76% worse than the S&P for the previous 5 years. And do you remember all the articles? “Buffett Used to Have It. But He Doesn’t Have It Anymore.” What did Buffett do? Buffett did nothing. He stuck to the underlying principles that had done so well for him, which I believe is another hallmark of successful, long-term, active investors. That’s really hard to do. And yet I believe that investors who do have that emotional make-up — who can understand that their emotions are the worst thing in the world for them … there was a great quote from a guy who wrote a book on the difference between —
BBR: Jim came SO prepared today! I’m just telling you, everybody
Jim: [laughs] Well I’m also writing this, so as I told you you’re getting the first look at this. There was a guy who looked at the idea that essentially, we’re running 21st century software on a 50,000-year-old hardware system that’s our brain. Right? So another research paper done in Sweden — you can tweet me @JPOshaughnessy and I’ll send you the link to this study — it was done on identical twins. And what the researchers concluded was that up to 50% of the way we invest is genetic, and is impervious to education.
Now — wow — just get your head around that! So the reason I’m coming to this point of view is, obviously, I want investors to do great, right? And I believe that the majority who might not understand and might deny that they have this emotional impulse. Or that they believe that they’re long-term investors and yet their actions demonstrate they’re not. That’s the type of person—
BBR: Because they’re reacting, and they’re making trades based off of that.
Jim: Yes. When you overweight the short term you create a reactionary model as opposed to an anticipatory one, right? What’s a better model? An anticipatory model. The only way you can do that is to understand the underlying process very thoroughly — like I just went through with Buffett and, by the way, a host of other great investors.
BBR: Basically, so if there’s a formula that works …
Jim: … And they can stick to it.
BBR: You just stick to it. So even when there’s bouts of volatility, or we have a financial crisis — or something — that ultimately it still pays.
Jim: It does.
BBR: So, wait — are you in favor of active?
Jim: I am in favor of active investing for a minority of investors out there today. The ones that do have those emotional frameworks and those personality traits. That really allows them to, as Cliff says, have these “superpowers.” I think from all the studies I’ve read and from my own personal experience in 30 years, the majority don’t have that and will ultimately do better off just indexing.
BBR: Just about 30 seconds left, so let’s go back to where we started and what you talked about back in March ’09. How you were telling investors — right? — to take a look at the market, that there were some great opportunities … Just quickly, so where are we now?
Jim: Well, where we are right now is: the United States we view as sort of fully priced; if earnings can continue to do well, then that full pricing isn’t horrible. We think international markets are much cheaper. We think emerging markets are the cheapest. But of course, we always know that when you get into the cheapest, it gets scary, and it gets hairy. There’s a great quote that is, “The treasure that you seek is in the cave you are afraid to enter.”
BBR: Oh my God. On that ominous note, or interesting note, we will leave it there. This was fun!
Jim: [laughter] Always fun with you, Carol.
BBR: “Active versus Passive.” I love that! Jim O’Shaughnessy, Chairman and Chief Investment Officer at O’Shaughnessy Asset Management, joining us right here on Bloomberg Radio.
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