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The Future of Active Management: Are Buy Side Analysts About to Become Extinct?

A finance professor and a student are walking together discussing the merits of the Efficient Market Hypothesis (EMH) when they come across a $100 bill lying on the ground.

As the student stops to pick it up, the finance professor says, “Don't bother – if it were really a $100 bill, it wouldn't be there.”

Modern finance education is almost entirely focused on explaining the markets using the EMH framework. You'll learn about the various forms of efficiency, about the CAPM and beta, and why you should only invest in passive, low-cost index strategies.

In other words, they will send the message that you’d better start taking accounting courses as a career Plan B, just in case you didn't get the memo that being a buy side analyst is pointless. After all, stock prices reflect all known information already.

Am I worried I will be replaced by an index fund?

Nope. And neither should you.

Let me explain ….

The Sports League Analogy

Have you have you heard the saying that all things become their opposite when taken to an extreme? Well, such is the case for the passive strategies recommended by EMH proponents.

The problem is that the EMH relies on informed investors immediately arbitraging away new information such that stock prices immediately reflect any new information. But wait a minute … If every informed investor become a passive investor, who would arbitrage away new information?

No one.

The markets would become an inefficient allocator of capital and EMH would fall apart. Or, I suppose, the world would become reliant on the capital allocation wisdom of the index makers. (For those that don't have firsthand experience with index makers, imagining a world run by index makers is enough to make you want to start drinking bleach immediately.)

The world needs informed traders to properly allocate capital and operate efficiently. So, just remember that you are doing your part for society by smartly allocating capital to the companies that will use it to make the world a better place (ahem, it's OK to pat yourself on the back now).

By now you should see the circular-reference error when EMH proponents recommend a passive strategy toward investing: EMH naturally concludes with a passive strategy, but EMH requires active investors.

The truth is we need a better model. I don't know exactly how it will work, but I do know it should look a lot like a sport league.

EMH proponents talk about how no value can be added through active management. I believe this to be true almost by definition, at least when you take the collective value of all active management. The game of active management is a zero-sum game. Somebody wins and somebody loses on every trade and the average is the market return.

To me, this is where the sports league analogy enters the picture. Teams will play a regular season that involves many games, but the collective record of the entire league will be .500. In every game, somebody wins and somebody loses. The same is true of the market.

What this doesn't mean, though, is that every team's record is .500. There are teams that win more than half of their games and teams that win less.

In the game of asset management, you aren't just trying to beat the benchmark; you are really trying to beat your peers.

Now, let's think about how a sports team becomes a winner: it has better athletes, better skills, and a better game plan than its opponents. That's exactly how you win in active management, with better analysis skills and a better investment process.

In every sport, though, the professional leagues are filled with super athletes with amazing skills. They are the best of the best, the cream of the crop. So what separates the asset management winners from the losers?

A better game plan, that's what. In our case, a better investment process is what matters since everyone in this business is smart. (Sidenote: If you think you’re smarter than everyone else, you are doomed. A little humility goes a long way toward long-term success in this business.)

Let's dig a little deeper into the investment process by going back to old Uncle Warren again …

The Superinvestors of Graham-and-Doddsville

The EMH was developed by Eugene Fama while doing his Ph.D. thesis at the University of Chicago in the 1960s. It was a near instant hit with academics and has become the teaching framework for finance professors ever since.

But what works in theory and in academia doesn’t always work in the real world. In 1984, Warren Buffet gave a speech and wrote a subsequent article for the Columbia Business School magazine titled The Superinvestors of Graham-and-Doddsville.

In this article he lays out how the value investing framework developed by Ben Graham has allowed a disproportionate share of like-minded investors to prosper in the EMH’s supposedly random game known as investing. To this date, Buffet's critique has not been touched by academics who instead choose to simply dismiss his findings as pure luck or chance.

Let’s take a look at the track records (using annualized rates of return) of the Superinvestors and make up our own minds:

Walter Schloss (1956 – 1984)

  • S&P 500: 8.4%
  • WJS Limited Partners: 16.1%
  • WJS Partnership: 21.3%

Tweedy, Browne Inc. (1968 – 1983)

  • S&P 500: 7.0%
  • TBK Limited Partners: 16.0%
  • TBK Overall: 20.0%

Buffett Partnership, Ltd (1957 – 1969)

  • Dow: 7.4%
  • Limited Partners’ Result: 23.8%
  • Partnership Results: 29.5%

Sequoia Fund, Inc. (1970 – 1984)

  • S&P 500: 10.0%
  • Sequoia Fund (net of fees): 17.2%
  • Sequoia Fund (gross of fees): 18.2%

Charlie Munger (1962 – 1975)

  • Dow: 5.0%
  • Limited Partners: 13.7%
  • Partnership: 19.8%

Pacific Partners, Ltd. (1965 – 1983)

  • S&P 500: 7.8%
  • Limited Partners: 23.6%
  • Partnership: 32.9%

Perlmeter Investments (1965 – 1983)

  • Dow: 7.0%
  • Limited Partners: 19.0%
  • Partnership: 23.0%

Now, go back and really soak in those numbers. Let’s look specifically at Sequoia Fund as an example, since they are the runt of the litter having managed a mere 720 bps over their benchmark per year for the 15 years leading up to Buffet’s article.

If you invested $10,000 per year in the S&P 500 index, you would have amassed a nice $317,725 on $150,000 invested. You would have effectively doubled your invested money along the way. Not bad.

But if you had invested that $10,000 per year in the Sequoia Fund, you would have amassed $570,477 on $150,000 invested. That is almost 4 times your money invested.

And thusly, I present the miracle of compound interest.

I already know what the EMH proponents are thinking: “There are random winners and losers in any game of chance, Buffet just picked those managers because of their track records.”


Buffet picked these managers in because they are all alumni of the Ben Graham philosophy of value investing, either directly from Ben Graham (Schloss, Tweedy Browne, Buffet, and Sequoia) or indirectly through Buffet (Munger, Pacific, and Perlmeter).

The academics will dismiss it as pure chance in a random game, but I’d venture to guess the odds of the Superinvestors track records being just chance are lower than the odds Lindsay Lohan resurrects her acting career.

Putting it All Together – Is Everyone is Right?

So who is right? Is Buffet right, or should you put your financial models and 12-Cs away and index as EMH proponents advise?

Fortunately, if we go back to the sports league analogy, I don't think we have to answer that question. In fact, we can say both sides are right and simply move along.

The EMH proponents are probably right at the macro level, but Buffet is probably right at the micro level. The EMH is likely right to say the markets are mostly efficient given the thousands of hardworking, smart buy side analysts gathering information and ensuring appropriate prices. Besides, active management is a zero-sum game as we noted before.

However, just as in a sports league where there is a winner and loser for every game, there can be teams that seem to win more often than others. Not all differences can be explained simply by chance or luck, otherwise what is the point of striving for anything in life?

Gordon Gekko: “You gonna tell me the difference between this guy and that guy is luck?”

Buffet identified one of those winning teams as the Ben Graham Value Investors. They have a boring offense, but their defense is quite stout.

So now let's circle back to the foreboding question in the title of this article: Are buy side analysts about to become extinct?

Considering value investors and the EMH have co-existed for decades, I think it's a safe bet to say that your future job won't be outsourced to an index-provider. Besides, the EFM needs active investors in order for the theory to work. Never forget that point.

Don't fret – stay positive. You'll find a job in money management if you are willing to work for it. Always remember that doom and gloom stories are more common because they sell more press, even though those stories rarely come true.

{ 10 comments… add one }
  • Shu

    I rarely leave comments on any site (not even after my ebay purchases). But after reading so many nicely written pieces on this site, I’ve finally decided to quit being lazy and show my appreciation.

    This short article is very well-written, fun-to-read and does a great job re-affirming my beliefs and understandings about active management.

    Please keep up the good work and best of luck to running the site.

  • Ken

    Very nice article! The most plausible and comprehensive proof that EMH is actually a half-truth. Thank you!

  • JOhn

    Excellent article. Especially enjoy the fact that the author does not attempt to say active VS. passive…..he frames it as active AND passive.

  • Will

    I just finished my undergraduate degree in economics and am working towards getting my MS Finance and CFA. I have to say, you have a great understanding of economics, i.e. you’re not one of these market cheerleaders you see on TV. With that being said, you are correctly right about index funds, but not to say they are without purpose. I am a big believer of David Swensen philosophy over at Yale and his view that passive management (ETF investing) is for those who do not have the time and resources of a true asset management teams(key word being TEAM). On the flip side, if you are financially literate, you can make great money being a value investor as that is how you truly make money. EMH is ridiculous concept as macroeconomic principles are based on micro-principles. Shiller (one of the founders of behavioral economics), theorized market bubbles back in the 1980s and well, it’s safe to say now that he was correct about the dot-com and housing market bubbles. Markets are not as black and white as some would like to believe, it just makes them seem intelligent when their looking to get their next paper published. It’s funny how people still believe as if markets run themselves, when markets are actually run by its participants. Nobel laureate Robert E. Lucas, pointed out the similar finding that public policy is inefficient due to human behavior, people react differently in their own self interest which in-turn diminishes efficient outcomes.

  • Kwasi Porterhill

    Hey, I am interested in going the buy side route.. What books would you recommend for people who desire to go that route?
    Also would you recommend working for a smaller hedge fund or one with more AUM, if you’re a less than 2 years analyst?

    • I have so many to list, but I’m going to start with an unconventional one titled Devil Take the Hindmost. It will give you some great perspective on the history of finance that is rarely discussed.

  • Dave

    You should know that the market is not zero-sum. In sports, the league average is .500, as you say. However the market return is not zero. Therefore, the market wins more than it loses. That is called “positive-sum”. When people say that in every trade there is a winner and a loser, they are making some pretty big assumptions: first, that the bid-ask spread is zero, and second, that each trade is done in perfect tandem (that is, entering a position in a security cannot be done when another parties goes flat; one party may only enter from flat to long at the moment a second party goes from flat to short, and those same exact parties will reverse their positions at the exact same moment sometime later and thus both be flat again). Those assumptions are ridiculous.

    • I think you are confusing absolute returns with relative returns. The absolute market return has nothing to do with the success of active management, it is the relative return to the market that matters. There are winners and losers relative to the market and they all average out to the overall market return in the end (which is the crux of the EMH argument). The tendency for the overall return to be positive is irrelevant when we are discussing the merits of active management.

  • John
    • I only skimmed the article because it was so long, but I’ve been hearing stuff like this about finance and every other industry a lot lately. Does it concern me? A little, but this has been the progression of mankind since the advent of specialization of labor. What I’ve seen so far is that decision makers have not been downsized on the buy side. There are just too many variables and nuances that machines aren’t capable of yet – they can only repackage information as exhibited in the article. One day they might be able to fully take over the world of finance, but that’s the day SkyNet becomes self-aware and we’re all out of a job.

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