Active Management - Old vs New
Updated: Oct 30, 2017
If you are tired of the same old story on active does not work, then this post might provide some perspective and, keep in mind, there have been billions of dollars of live, successful trading since 2010 underlying these findings. Alright, take a good look at this picture and then let's dig into it.
Active. What is active in today's world of technology and computer-driven trading? It is for sure different from that of your proverbial "father's Oldsmobile". I can't tell you how many mutual fund institutional managers think that they are active when in fact they are closet indexers and their performance represents that point. So, I have learnt that to beat passive/closet indexing, an investment strategy by default must be truly active. That means that no matter what return factor you invest in (eg. value, momentum, min vol, quality), in today's world of high information flow, active requires a higher frequency of data input, analysis and decision-making (read: Elevated Rebalancing) to attain any level of substantive risk reduction and return enhancement over the tired, outdated "active" of old. Any investment strategy, does not matter how much money or how big the name behind it, will go the way of Oldsmobile IF you forsake technology and its implications on alpha capture and market structure. Meaning, if your investment strategy/manager/advisor/computer does not analyze and make elevated rebalancing decisions anywhere from daily to monthly, your odds of accessing sustained, net positive alpha are slim to none and, worse yet, your odds of attaining Negative alpha are very high. Reread this last point as many times as necessary and then do something about it.
Find real active that can adapt to markets or go passive and hope for the best.
Risk-Based. First item Equity risk. Intuitively, I believed that there is a natural offset (negative correlation) that exists in infinity to two forms of risk that always arise in stocks: simplistically prices that are cyclical (like a sine wave) and momentum-like (keep going in one direction). I surmised that if a portfolio is constructed where the risk weight on any given stock is a function of both the cyclical and momentum forms, then the portfolio would benefit from a natural, persistent reduction in portfolio risk while capturing a majority of the returns offered. Simplistically, imagine a strong baseball outfielder who can quickly assess both the arc and momentum of a hit ball to determine how to best position himself to catch it. The fielder needs to be properly trained and practiced and, importantly, be able to assess these risk elements continually (read: Real Active from above) to improve his odds. This is how we define Equity Risk - simply what arises out of the movement of a stock's price up and down over a given timeframe.
Market Risk is a function of now integrating our individual stock risk assessment with that of the market over a given timeframe. And, Cash Risk is that component of our resultant portfolio that may arise due to carrying cash given that, while it is a great hedge against loss, it also can cost you in missed returns.
Collectively now, we have formed our risk analysis to encompass that of the individual stock relative to the market and, finally, against that of holding cash. Doing all three is central to our risk analysis and is the hallmark of Risk-Based decisioning.
Two important takeaways from this to ponder:
1) Use of prices only for stock risk analysis - not to make a trading decision
2) Higher analytical/decision rate drives greater potential alpha
Takeaway #1 - Any of you Efficient Market Hypothesis (EMH) Types will understand the direct implications of using prices for analysis - it is technically the only way we can rely on clean, efficiently determined information that reflects publicly available information. Contrast this point with what the majority of active managers are doing in mutual and hedge funds - using prices to determine their profit/loss, which is used for making a decision. Or, doing any form of standard fundamental analysis that results in a predicted stock price value as of today. This form of "active" management directly contradicts the basic precept of the EMH, which means you have limited to no chance of beating passive investing even before active fees are paid! Remember, price is king (what I led of with in an earlier post), don't bet against a $36T marketplace, you will lose in the long run.
Takeaway #2 - Under the assumption, albeit a big one, that you figure out how to use price only (no predictions and betting against price) for analysis, then doing that same analysis more often should in theory drive higher alpha, be scalable and be persistent. These last two criteria are as important as the first (higher alpha) since we want the investment process to support many investors (scalability) and not come and go like the tide (persistence). Here again, these criteria have escaped the majority of active managers for the better part of 15+ years.
So, the answer to old active (now passive) is embedded in these two takeaways and if you talk to old active on these two takeaways alone, most will either not understand it or be conflicted by their own lack of ability to get on top of them on behalf of their investors or, worse yet, their paycheck depends on maintaining their old active ideas.
investing. Last element, we move to the conception of using a defined, robust investment process in broad, diversified portfolios and even across asset classes. I am not a believer in gambling in the stock market; eg, picking one stock and putting all my money on it. I do believe in spreading money around to be diversified, like indexing. But, diversification comes at a cost too. That cost is the return differential of a diversified portfolio of stocks (index-like) to that one high-flyer stock your best friend made a killing on. Unfortunately, if luck, bravado and bliss don't seem to have been imparted to people like you and me, we must turn to more realizable investing options.
Bottomline: our philosophy is always one baked on risk, where decent returns is the outcome. Can you have both in a broad diversified portfolio? Yes, if you choose to be new active (as we suggest above) vs old active, where old may drive you to go passive. Frankly, in a choice between old-line "active" and going passive, I go passive any day. No matter how big, Blackrock, Blackstone, Black anything, old active managers mathematically won't beat a representative passive benchmark over longer periods of time, even if they did it for the past 50 years, unless they can demonstrate the key elements noted above! Markets evolve, and old ideas die a slow painful, sometimes expensive death, especially it seems in investment management.
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