Two institutional managers I do know — one at a Fortune 500 defined profit pension fund and one other at a municipal pension fund and later an endowment — consider in going all-in on lively management. To them, a 100% lively allocation will not be only okay but desirable. In fact, anyone with any knowledge concerning the statistical odds of choosing outperforming lively managers knows how unbelievable and wrongheaded this approach is.
Which is why I ask lively management’s true believers to share their academic and skilled insights on why lively is the higher path. I’ve found it startling that so many in our industry, after they offer any opinion on all of it, provide so little in the best way of strong and substantiated sources to back up their perspective.
In my view, I actually have six observations, detailed below, that help guide my approach to the lively vs. passive query. In fact, they’re removed from exhaustive.
In any case, manager selection is hardly an easy process. At bottom, it begins with the idea that lively managers can outperform and that those managers could be identified ahead of time. To ensure, the manager selection literature has a vocabulary and an inexpensive framework to think concerning the challenges, however the holy grail of the dilemma — knowing when to go lively and when to go passive — stays elusive.
Indeed, lively evaluation hinges on reasonable forecasts of ex-ante alpha and lively risk each by way of optimizing alpha and strategic asset allocation.
To serve our clients well, we’ve to maintain our eyes wide open on these issues. Energetic management’s record is dismal. The SPIVA research paints a fairly troubling picture. So does Winning the Loser’s Game by Charles Ellis, CFA, and “The Energetic Management Delusion: Respect the Wisdom of the Crowd” by Mark J. Higgins, CFA, CFP. Just last month, Charlie Munger described most money managers — that’s us — as “fortune tellers or astrologers who’re dragging money out of their clients’ accounts.” While Munger is all the time great for one-liners, the criticism stings and possibly hits just a little too near home for lots of us.
Yet, I actually have not forsaken all lively for passive. But I’m taking a tough look, together with others in my firm and within the industry, at work through these challenges. Make no mistake, our industry will proceed to bend toward passive. But there are possibilities for lively. On the subject of manager selection and the lively vs. passive debate more generally, I like to recommend keeping the next in mind:
1. There Are No Bad Backtests or Bad Narratives.
This is very true coming from sales or business development personnel. But while it is straightforward to sound good and construct a compelling story, it is far harder to present a quantitative approach that dissects attribution ex-post and understands ex-ante how that process can materialize into alpha. It’s a tall order and no pitch that I actually have heard has ever done it well.
Investors shouldn’t need to figure it out on their very own. It is affordable for them to expect lively managers to define and measure their ex-ante alpha, especially in the event that they are simply extrapolating it from the past. But investors have to guage that ex-ante expectation or have a well-developed forward view of where that alpha will come from.
2. Non-Market-Cap Indexing May Help Discover Market Inefficiencies.
This extends lively management into index selection and management. Even small disparities could make an enormous difference in relation to how a sub-asset class performs in an index. For instance, while market-weighted and designed to reflect the small-cap universe, the S&P 600 and Russell 2000 have very different inclusion and exclusion criteria that may result in material differences. Furthermore, index variations may seek to capture the well-known aspects documented in academic and practitioner research — the so-called “factor zoo” — that too many have summarily dismissed.
3. Are Our Biases Our Friends?
If we truly query the efficiency of a market, we could have a basis to prejudge a specific corner of the investment universe and invest accordingly. But such beliefs must transcend the final and the apparent: We want something more concrete and specific than “the markets can’t be efficient because people aren’t rational.”
4. When in Doubt, Go Passive.
We’re all imperfect, however the strength of our convictions matter. If on an ascending 1 to 10 confidence scale, we’re only at 7 and even an 8, we must always go passive. Given the chances, “warm” will not be enough of an inclination to go lively.
5. Expenses and Manager Ownership Can Make for Good Screens
Does an lively manager charge exorbitant fees? What does the fund’s ownership structure appear like? If the answers don’t reflect well on the manager or fund in query, it could be idea to avoid them.
6. Consider a Core-to-Satellite Approach
This provides us a mistake budget. We will, for instance, limit our lively exposure to not more than 20% to 30% of our policy allocation. This fashion our passive exposure will all the time give us reasonable expectations of returns within the top-quartile over the long term. Top-quartile is impressive.
On a bigger level, it could make sense to reframe the entire lively vs. passive debate. The query — lively or passive? — might not be the proper one to ask. Am I getting exposure to the market that I cannot get through a benchmark? Is there an actual inefficiency on this market? Perhaps these are the questions we must always be asking ourselves.
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All posts are the opinion of the creator(s). As such, they shouldn’t be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the creator’s employer.
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