The millennial advantage
The math is simple.
Investing is a zero-sum gamei and active management is more expensive than passive management. Which means the average active dollar will underperform every passive dollar. Nobel prize-winning economist, William Sharpe outlined this math in his famous 1991 research piece “The Arithmetic of Active Management.”ii
The math is correct but the conclusion it makes about active management isn’t.
This has led to the dismissal of active management. Those that haven’t devoted much time to this subject have been presented with a conclusion from Sharpe’s research that suggests “you should invest in a low-cost passively managed fund.” This is the camp most millennials fall into. In a world where there’s always someone or something competing for our attention and a long message is 140 characters, many of my millennial peers have accepted this conclusion as truth and swiftly moved on. Case in point, millennials use ETFs more than any other age group and that usage increased 60% in the past three years, according to data from TD Ameritrade.
There’s no denying that obtaining above-average returns is difficult. The mixed track record of the average active manager has only heightened this perception. However, not all managers are average. Just like if you were to take a cross-section of basketball players, it’s safe to assume the average player won’t make it to the NBA. Doesn’t mean no players will. Those potentially NBA bound would have common characteristics like they’re taller, faster, can shoot better and jump higher. If only there was a way to identify active funds more likely to be better-than-average… Fortunately, there is. Common characteristics within funds that outperform over the long term include: a low expense ratio, a low turnover ratio, long manager tenure, high manager ownership and a long-term incentive structure. Analysis by Capital Group highlighted that a portfolio comprised of funds in both the lowest-cost quartile and highest management ownership quartile often beat their indexes. Specifically, U.S. large-cap funds that have these characteristics outpaced the S&P 500 Index in 100% of rolling 10-year periods! International large-cap funds outpaced the MSCI All Country ex USA Index in 93% of the 10-year periods!iii
The reality is that millennials should be the most open to the idea of active management. Why? Because compounding will have a disproportionate benefit to those that have time. Take someone in their late 20s, a few years out of college and who’s saved $10,000 they don’t need until retirement. Let’s look at a 6% passive return versus an 8% active return. This 2% translates into a meagre $200 in year one. Big deal. However, this fails to address the power of compounding. Over 40 years (right around when many millennials plan to retire), this extra 2% of compounding at 6% versus 8% adds up to approximately $115K! In this scenario, it’s the difference between $102,857 earned from passive investing and $217,245 from active investing. Millennials’ greatest investing advantage is time. Something that sound active management can help millennials exploit.
I was fortunate to have appreciated the benefits of active management and the power of compounding from a relatively young age. Many of my peers outside my workplace still question my decision to pursue a career in active management and remind me of the math William Sharpe outlined 25 years ago. I agree with his math, but remind them that there will be those who are above average and point them to the other math, compounding.
If you can take the time to find a manager (or an advisor who will find a manager for you) that will outperform, as a millennial you have the advantage. That 2% will make a big difference when you’re 65!
iiWilliam F. Sharpe, “The Arithmetic of Active Management” https://web.stanford.edu/~wfsharpe/art/active/active.htm.
iiiCapital Group, "Expect More From the Core", Investment Insights, September 2014.