Last week I described the top 6-10 things that hurt active management, along with 3 honorable mentions. This week I hit the really juicy things in numbers 1 to 5. In brackets are those who I think bear responsibility for the item. But a slight side step, first. I received a good suggestion from pal, Gordon Ross, CFA which is to invite each of you to provide your own ranking of the Top 10. Feel free to mix in the honorable mentions, as well. And (and this is a big AND) also free to name some of your own Top 10 Things That Hurt Active Management.

Let’s roll…

5. Confusion About Risks

[research analysts, portfolio managers, directors of research, chief investment officers, distribution, the C-suite, clients, advisers, investment consultants, asset owners, and anyone else I did not mention]

I have written about this for over 20 years. It was my Masters thesis at the University of Colorado (go Buffs!), in multiple articles, and even in Return of the Active Manager. Yet, the industry still buys into the bs notion that volatility measures such as β and σ are equivalent to risk. Yet, only in finance do we define it in this way. The entirety of the error dates back to Markowitz, then Sharpe, who were borrowing statistical concepts to bring mathematical rigor to portfolio construction. But it is wrong, and demonstrably wrong. As Bob Newhart is famous for saying, “STOP IT!”

Ridiculously, these errors have exhausting effects on the returns of active investment managers who are measured improperly by things like Sharpe ratios, for example. At the end of the day, the greatest risk, beyond chance of loss (everyone else outside of finance’s definition, including in insurance, a business obsessed with risks since they underwrite them), is loss of capital appreciation due to using volatility as a risk measure. Don’t believe me?

In 2017’s “The Rate of Return on Everything, 1870-2015” Jordà, et. al in Table 3 show that T-bills have the highest Sharpe ratio globally and for the 145 year period at 1.38 vs. equities of 0.47. But that $1 invested in T-bills grew to $678 vs. equities at $2,690,552. So, investment industry WTF is up with using the wrong risk measure? STOP IT!

How to think uniquely think about risk and how to assess it to boost α is one of my secrets shared with consulting clients. Hint!

4. Lazy Advisers

[advisers]

I have had many conversations over the years with advisers and this is how they frequently answer this question: “Why do you only use passive funds?”

Answer 1: “Active doesn’t beat passive, net of fees.”

On the surface that may seem true. The more informed among advisers quote Morningstar, SPIVA, or academic research proving this is so. 2019’s SPIVA says 89% of active investment managers do not outperform their benchmark.

However, if you look at the methodology that is used by both there are problems with their sweeping conclusions. Most importantly, they follow the traditional academic standard of including the performance of funds that disappear to minimize survivorship bias. What Voss, how is that a problem?

It is a problem because active investment management is a competitive endeavor. If you win you do drive your competition out of business. In fact, that is the point. In capitalism we celebrate the likes of Amazon specifically because they vanquish all comers.

What % of the SPIVA database are funds that closed in a 15 year period? 55%. Thus, if you get rid of those funds then what you see is that 24% of active investment managers actually outperform their benchmarks (89% – 55% = 34%, 11% ÷ 45% = 24%). Thanks to Jeffrey Ptak for pointing out the error in judgment in version 1 of this post when I concluded 66% outperform. Grazie mille, Jeffrey.

This does not sound encouraging, except that multiple pieces of research find the story isn’t so obvious. For example, Wermers (2000) found that the average stock held by equity funds generates 130 bps of α. While Berk and Green (2004) report 80% of equity managers display enough skill to cover their fees, so long as AUM does not get too big (more on this below). In 2010, Cohen, Polk, and Silli found that the top 20 holdings, research analysts best ideas, deliver 160 to 210 bps on average. More recently (2018), Cremers, Fulkerson, and Riley in “Challenging Conventional Wisdom Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds.” They concluded that there is evidence of considerable skill among primarily US active equity mutual fund investment teams. They also found multiple problems with much of the research that is widely quoted by advisers.

So, what accounts for the discrepancies? Generally speaking what is found is that research analysts are very good at security selection; in fact, net of fees α additive. What happens is that all of the α is lost by poor portfolio management. There is a hint here about how firms could overcome this problem that features in consulting engagements. But, more to this bullet point…advisers, the ones that I am accusing of being lazy, frequently conduct their own form of asset allocation with each bucket filled up with by passive products or ETFs. More on this just below.

Answer 2: “Active is harder to sell. With a passive product, my client knows exactly what she or he is going to get…the market.”

Again, this is laziness on the part of the adviser. First, the job is to put your client into products that have the highest probability of their financial goals being achieved. If it is an active product that is best then you are obliged to risk a tougher conversation with your client than a passive product. Second, I have heard advisers say they need funds/products to fill their asset allocation categories of: equities, fixed income, real estate, commodities, cash, etc. Said another way, advisers are trusting that their asset allocation strategy is the real value add, not the funds.

While that may sound like the opposite of laziness on the part of the adviser, I beg to differ. Why? Because how many advisers evaluate the success of their asset allocation strategies with the same degree of precision that they do the performance of individual active funds? How many advisers say to their clients, “You know what, I ran the numbers on my asset allocation strategy for you, and I messed up. I should have had you more invested in assets of type x over the last y years.” How many take that data and then try and improve their asset allocation process? After all, the allocating adviser is adding in active management, their own, to the process. How is this measured?

Answer 3: “I believe in active, but cannot identify which ones are likely to succeed.”

Now this is a legit, non-lazy answer. Want an answer? My co-author and I in Return of the Active Manager reveal the criteria of outperforming active investment managers, based on thorough research.

I make my living as a consultant, not as a writer. Contact me, because my job is to help you and your investment team get better.

3. Distribution Misalignment

[distribution, the C-suite, boards, advisers, clients]

Here I am referring to the fact that many funds have the wrong shareholders. Based on what? Primarily there is a misalignment with the underlying investment philosophy, or the investment time horizon. An example of misalignment is a midcap value manager whose average time horizon is 5-7 years with an investor who invests because the fund was just awarded a 5^th star from Morningstar and who trades in and out of funds chasing returns, on average every 12-18 months.

This is the most subtle of the Top10, in my opinion. But it is deleterious to active returns to have misalignment with your shareholders because it is possible for the two parties to work against one another. When the stock market tanks, value managers want cash inflows, not redemptions. Volatile return fund managers, like momentum folks, want someone that can stomach the downs, as well as the ups.

You may disagree that this should be ranked so highly, but because only a few firms work at getting the right investor, not just an investor, this ends up just being an accepted cost of doing business, rather than an α opportunity.

How to better align the distribution team with the portfolio management team is, you guessed it, a part of my work as a consultant.

2. Style Box & Tracking Error

[the whole industry, but mostly investment consultants, asset owners]

Ironically, the style box and its enforcement mechanisms like tracking error, were created to explain performance after the fact, rather than as “manage to” criteria before the fact. Fama and French in the early 90s acknowledged a couple of bugaboos in their efficient market hypothesis, the value and small cap effects. That same year, several months later, Morningstar launched its Style Box; now a Frankenstein’s monster roaming the investment landscape wreaking havoc.

Said as simply as I can, “If you want returns like no one else is earning, then you have to do what no one else is doing.” Duh. Double duh…and triple duh! The Style Box and tracking error are mechanisms for punishing outperformers and for minting closet indexers and bland sameness. The point of active investment management is not to perform like the benchmark, but to leave it in the dust, to destroy its performance, and to never look back.

Recall from this discussion my point about volatility? It is irrelevant over long periods of time, typically 5-10 years. Remember my point about asset allocation strategies not coming under the same scrutiny as the managers making up the strategies themselves? So, if you marshalled up these as reasons in defense of the Style Box and tracking error, check yourself.

One more analogy, straight from Return of the Active Manager:

“Let’s look at an example from another field. There is only one Usain Bolt. Yes, it is possible to beat Bolt in a 100-meter dash, the equivalent of a rule-based, defined context…a race. But is it possible for another sprinter to beat Bolt if he is asked to be the same height, weight, have the same stride, the same acceleration, the same lean, and so on? No. The reason is that Usain Bolt is not the standard. The standard is winning the race!”

Unshackle investment managers to be their very best. End clients are the beneficiaries.

Last, if you insist on using the Style Box, then I insist you prove its quantitative worth, not just its convenience. [Ditto: Star ratings]

1. Business Models

[the C-suite, boards]

It is my strongly held opinion that most active investment management firms have uncompetitive business models. Models that actually are not about delivering the most important thing: competitive returns.

There are multiple points here. First is that when the mutual fund industry was created and its revenue source was established as the management fee that the current era was clearly not foreseen. A management fee, a coupon clipped on total assets under management, is a commodity pricing model. It says that the only thing that matters about a fund is how much money is in the pot. Stupidness.

What matters for active managers is if you can deliver outperformance. Even before Bogle and Vanguard what mattered was performance. This is a fact. Yet, business models have not been adjusted so that managers earn their money based on what their customers actually care about. Ugh!

Active investment managers need to start experimenting with their business models if they want to survive well into the future. Aperture has done the right thing. They charge passive fees unless they beat their benchmark over a contractually mandated time horizon. Then they get a chunk of the outperformance. Awesome sauce. In return for this they have asked clients for the right to manage products with unique prospectuses, and unique opportunities for its managers to be their very best.

Succinctly, active management done well is a luxury good and it should not have commodity pricing.

Because of the assets under management coupon clipping, most active firms have tried to asset bloat up until the point they feel they can still manage their products. More bloat = smaller fishing ponds due to liquidity and the “40 Act” = harder to deliver outperformance.

Has any client ever said or requested that the fund they invest in be big? Is that even a criterion that passes through the minds of any client? No. But that is how the whole of an asset management firm is managed at the C-suite. Revenues are generated by increasing AUM. Yes, by earning outsize returns firms can deliver more revenues, but we know that earning those returns is harder if the funds are bloated.

So, this business model is not in alignment with customers. What other industry can exist for long without delivering what its clients want from it?

Last, publicly traded asset management firms are not good for clients, in general. I say this even though some of my best clients as a consultant are publicly traded investment managers. But, the problem is that the best way to manage this kind of firm at the C-suite is to consolidate, consolidate, consolidate to bloat up assets to preserve an ever shrinking net income line. C-suites build a broad product offering, presumably for the benefit of clients. Then the mandate to the distribution team is market the heck out of the 4- and 5-Star funds. When those ratings inevitably decline, a broad product portfolio public firm likely has new 4- and 5-star funds to market, all over again.

But again, is this good for, or right for clients? Investment management is a profession, first, and a business, second. Publicly traded firms have the whole thing backwards.

In conclusion, if you look back at my Top 10 Things That Hurt Active Management you can see that I think the whole industry has evolved in ways that hurt active investment management. This is a bad outcome for our clients who need competitive products that have a greater chance of satisfying their financial goals. That said, I put most of the blame on active investment managers themselves. Going back to my Usain Bolt analogy, this is a sport, an event, and a race they have agreed to compete in, and it is time for them to start doing that, fbo our valued end clients.

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