Passive Aggressive

January 2018

 

“When it comes to fund managers and market strategists, this year's hero usually turns into next year's zero.” – William Bernstein

 

There is an ongoing battle between proponents of passive and active funds. At Monmouth Capital we take care not to be dogmatic. This allows us the flexibility to choose the most effective solution as appropriate. Nonetheless, the narrative of the benefits of active management, while compelling, have too often not delivered in terms of net excess returns.

We look at the challenges involved in the use of active managers and where they may still play an important role in client portfolios.

The Active Challenge

The use of active managers is beset with well-documented issues that are, in some cases, difficult to overcome:

1. Identification.  

There are managers that outperform but it is difficult to predict consistently who they will be. All the common (and seemingly sensible) metrics for identifying funds that will perform well in the future tend to be unhelpful:

  • past performance

  • effective communication

  • a good “story”

  • branding

 

The list goes on.

2. Cost.

The average active manager charging more than a passive equivalent starts at a cost disadvantage. They must make up this difference and then add returns on top to come out ahead.

In fact, using style analysis, a statistical method to explain the portions of returns that are due to market factors or manager skill, one finds much of the returns of active managers is explained by their particular factor risk exposures (e.g. to the UK market or to quality stocks).

If this is true, one can broadly replicate ‘active’ performance at lower cost; put another way, lower cost means guaranteed additional returns.

3. Too much talent chasing a limited pot.

Beta, the market return, is available to all investors. Alpha, excess returns, is finite. There is only so much of it to go around. Therefore, when it comes to active fund management, the salient factor is not how good you are but how good you are relative to your competition.

Fund managers are almost without exception bright, well-trained, committed and backed by substantial resources. We have never had so much skill in the investment industry. This leads to what Michael Mauboussin calls the paradox of skill:

4. ‘Dumb’ is enough.

Received wisdom in the investment industry suggests that we must try and outperform the index.  Why?  What is most important is the return required to achieve the portfolio goals for a particular client. Beta returns are, for most, more than enough.  If we desire returns above the index then we can tilt to risk factors that add to returns such as value, momentum and quality (with many caveats on implementation and time horizon).

 

5. Dynamic asset allocation.

The general method of managing portfolios is to use a passive asset allocation with active fund choices. Substituting this with an active asset allocation and passive fund choice is a powerful alternative.  The use of passive funds implies simplicity; this is not so. In fact, dynamic adjustment of asset class exposure is a sophisticated and robust method for managing a portfolio. It is also far more tractable than identifying winning fund managers.

 

The Active Edge

Despite these challenges there are situations in which active managers can play an important role in client portfolio construction:

  1. In cases where they can provide optionality. This is most obvious in the alternative space. We may be sniffy about the incentive structures of hedge fund managers but they have a place in helping structure effective portfolios (see our thoughts on optionality here).

  2. If benchmarks are poor.  A bad benchmark should be avoided. This is more evident in fixed income benchmarks or illiquid assets or regions (such as frontier markets).

  3. When investment flows become narrow. This is a situation that may become more prevalent in the future. Passive funds channel narrow but large volumes into the market (the particular benchmark) leaving the rest of the market underbought. In this environment active managers have a chance to demonstrate skill and add value.

  4. Evidence that managers can add value in asset class. There are always domains where active managers can demonstrate an edge and where skill pays off. This can be due to informational advantages, or access, or just avoiding errors. It is preferable if this is true for active managers as a group in the domain rather than the chosen few. This reduces the error of choosing the one who may be nearly right but accrues none of the excess returns.

 

There is a tendency to move to extreme positions in market beliefs. This is seen in the debate between active and passive fund use, or currently cryptocurrencies. We are not dogmatic and maintain a flexible toolbox bounded by core principles.

 

There will always be a place for active funds in a portfolio but investors should look carefully at the criteria they use to select them.

“It’s not that managers have gotten dumber. It’s precisely the opposite. The average manager is more skilful than in past years. The paradox of skill says that when the outcome of an activity combines skill and luck, as skill improves, luck becomes more important in shaping results.” - Michael Mauboussin

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