Asset Allocation, Asset Managers, Defined Benefit, Institutional Investors, Pension Funds, Public Funds

Arizona PSPRS Rejects Active Management of U.S. Public Equities

When investing in U.S. equities, index funds are the way to go, according to Bill Thatcher, portfolio manager, equities and private credit, at the $10 billion Arizona Public Safety Personnel Retirement (AZ PSPR). He says he’s done the research to prove it. Thatcher will publish his research on the active versus passive question, which touts his concept, The Purity Hypothesis, this winter in the Journal of Index Investing.  The paper is an update to his two previous articles on the topic, published in 2009 and 2012, in the Journal of Investing and Journal of Index Investing, respectively. To come up with his findings, Thatcher looked at more than 150 independent time periods across the Russell U.S. indexes from 1979 to 2017.

Bill Thatcher, portfolio manager AZ PSPR

“Conventional wisdom says that domestic equity indexing is more likely to outperform active managers in efficient markets, like large stocks, and is more apt to underperform active managers in less efficient areas, like small stocks,” Thatcher originally wrote in 2009.  But the data over a 10-year period does not support this idea. Instead, it shows that “domestic equity indexing tends to outperform active management in the highest-returning asset classes and tends to underperform active management in the lowest-returning asset categories,” he wrote.

The research is simple to understand, according to Thatcher, who says that he is surprised that more investors are not talking about it. To conduct his most recent study, he looked at the stock performance of the Russell domestic equity indexes over the last 39-year period. The categories at which he looked include core, growth and value stocks broken down into small-, medium- and large-cap stocks, resulting in nine boxes of investible equities, which can be viewed in the Morningstar Style Box.

What he found was that “within U.S. equities for the asset categories that do the best, index investing takes it to the active manager and wins.” Conversely, in the worst performing asset categories, the index tends to underperform active managers. But that still doesn’t do much for the reputation of active investors because, as Thatcher puts it, “Why would you want to invest in the worst performing categories?”

Thatcher said that “it’s tough to find active managers in U.S. equities who have consistently outperformed their index. That’s why the pension fund currently has about 30% of its portfolio invested in equities, most of which are passively managed. “We have not hired active managers for public equities, U.S. or international, for a while,” Thatcher said. “We think it’s easier to find active managers who have outperformed in other asset classes.” AZ PSPRS uses active managers for its private equity, private debt, real estate, real assets and hedge fund portfolios.

The fund’s portfolio is currently consists of 16% U.S. equities, 14% international equities, 12% private equities, 16% private credit, 12% global trading strategies, 9% real assets, 10% real estate, 4% risk parity, 5% fixed income and 2% cash.

The purity hypothesis

Thatcher’s purity hypothesis is based on the fact that most active managers do not cleave purely to their investing style when investing for their portfolio. The result is that they tend not to perform as well as a high-performing index funds in the same category.

Take large-cap growth stocks, for example. “Large-cap growth stocks have been crushing everything for a long time; they are the best performing class.” And what Thatcher’s research has found is that the large-cap growth index typically outperforms the large-cap growth active managers in that box, Thatcher said. That’s because the large-cap growth active managers typically don’t have their entire portfolio invested in large-cap growth stocks. “These active managers are not style pure,” Thatcher said. “They get into the situation where in the best performing box, they will also have these other non-large growth stocks, maybe some medium growth stocks, that are not performing well and that drags down their return versus the large-cap growth index,” he said.

The concept works the opposite way in the worst performing style box. If small-cap value is the worst performing box and all active managers are not style pure, then the companies in which they invest outside of small-cap value, such as small blend or midsize blend, will pull the active managers’ investment up, and help them to outperform the index, Thatcher explained. What it boils down to, he says is thatactive managers are punished for their style impurity in the best performing asset class and are rewarded for style impurities in the worst performing asset categories.”

“When an asset class does well, an index fund in that asset class does even better.”—Steven Dunn, founder of Dunn’s Law, which seeks to explain certain elements of  fund performance.

Implementing the purity hypothesis

So, how should investors best use the purity hypothesis concept to boost returns? Thatcher uses current market performance as an example of how it could work. Growth stocks have been outperforming the market up until recently, but “it looks like value stocks, after many years, could be starting to outperform growth, at least in the short run,” he said. So for those who see this as an on-going trend, Thatcher’s recommendation, based on the purity hypothesis, would be “to tilt their portfolio toward value stocks, depending on a number of indicators.” And they should use index funds to do so. “Because, if your tilt is right and value stocks outperform growth, then active value managers as a group are likely to underperform the index. It’s just another reason to avoid active managers,” Thatcher said.

Are active manager the better choice for international equities?

While passive is the way to go with U.S. equities, Thatcher cautions against using the purity hypothesis when looking to invest in international public equities. That’s because of the fluctuations in the currency markets. “If there were not currency movements, maybe the same thing (purity hypothesis) would occur, but we don’t know,” he said.

Thatcher is also quick to point out that he didn’t come up with the initial idea behind the research he is touting. He credits William J. Bernstein, the editor of the quarterly asset-allocation journal Efficient Frontier and a principal at Efficient Frontier Advisors, an investment advisory firm, and Steven Dunn, the founder of Dunn’s Law, for coming up with the basic theory in 1999. Thatcher was so impressed with their research that he began updating it every few years. He is surprised that it hasn’t gotten more traction. “The data is really strong, and people don’t know about it yet,” he said.




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