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Does active management make sense?

The discussion on whether active management makes sense is very present in the investment management community. Poor observed investment performance tends to speak against active management. In addition, equilibrium or zero-sum arguments are used by proponents of indexed solutions. Very often the question is discussed without a common definition of what active management means. Indeed, active management, when properly defined, makes sense and is even a necessity. But successful active management requires capabilities which are scarce to find.

One of the most often heard question in the investment management industry is whether active management makes sense? Answering that question turns into a philosophical discussion. The question is discussed without a common definition of what active management means.

MY DEFINITION OF ACTIVE MANAGEMENET

Let me start by giving my definition of active management:

Active management is  transforming a personal opinion into one or more portfolio holdings that differ from given portfolio holdings with the goal to achieve a return that is superior to the one of the given portfolio.

The personal opinion may be of broad nature, like equities will outperform cash because of their inherent risk premium, or specific like the UBS stock will outperform the Credit Suisse one, because UBS has superior management capabilities in investment banking that will lead to an enhanced return on invested capital. Opinions are generally formulated in relative terms with respect to the given portfolio.

In my definition of active management, the given portfolio describes the reference portfolio against which active management is defined and opinions formulated. It may be a benchmark portfolio, but it may also be holding a risk-free asset, of which cash is a reasonable proxy.

The mechanism of transferring the formulated opinion into portfolio holdings is called implementing an investment decision, the opinion often being termed forecast or market view. Ideally, forecasts are based on skill rather than luck.

This leads me to reformulate by definition of active management.

Active management is the application of skills to implement investment decisions through holding a portfolio that differs from a given benchmark with the goal of outperforming it

A PRELIMIARY ANSWER IN FAVOR OF ACTIVE MANAGEMENT

Holding any portfolio is, according to my definition of active management, an active investment decision and thus the answer to the question “Does active management make sense?” must be yes, otherwise why hold any portfolio.

Indeed, holding an ETF on the S&P 500 index in the context of a cash benchmark, is active management as it relies on the opinion that the S&P 500 index will outperform cash. It is important to note that it is not the ETF provider who adds value through active management, but the investor selecting the ETF. It is that small nuance of who decides that often leads to the philosophical discussion about the value of active management.

TWO MAJOR FLAWS WHEN ARGUING AGAINST ACTIVE MANAGEMENT

Proponents of efficient markets argue that it is impossible to consistently beat the market. They support their view by the arguments that if it were possible to consistently beat the market, then every rational investor would do so and thus the outperformance would be arbitraged away. But this argument as two major flaws often ignored:

  • First, the argument assumes that every investor has the same utility function. But in real live, different investors have different utility functions. For example, an investor with EUR as reference currency has a different utility of the return of a U.S. stock than an American investor with a USD reference currency. In addition, many investors have subjective preferences encoded in their utility function, like a preference for their home market, that is independent of any return and risk expectations.
  • Second, the argument is based on the assumption that all investors behave rationally. From a theoretical point of view this is sound, but in reality, unfortunately, or fortunately, not all investors behave rationally. Just have a look at the assets under management in underperforming fund products from major asset managers.

PRE-CONDITIONS FOR SUCCESSFUL ACTIVE MANAGEMENT

Successful active management, that is, answering the question “Does active management make sense?” with yes requires focusing on

  • who formulates which opinions leading to which investment decisions, and
  • against what portfolios or benchmarks are those decisions taken.

Therefore, it is key to understanding the rationale behind these focus areas. There exist broadly two dimensions to approach these areas, that is,

  1. the return dimension, and
  2. the risk dimension.

RETURN DIMENSION

  • Opinions are based on expected cash-flows, like coupon payments or dividends.
  • Opinions are based on publicly observable imbalances from a given market model which different market participants may or may not believe in.
  • Opinions are based on timing with respect to expected or required cash flows.
  • Opinions are based on proprietary information processing and are different from opinions of other market participants.

RISK DIMENSION

  • Opinions are based on the transfer of risks and associated expected rewards for these risks.
  • Opinions are based on differentiated perceptions of risk with respect to the other market participants.

Answering the question whether active management makes sense to you, boils down to assess whether or not you are capable of formulating opinions, as described, that turn out to be true. As can be seen, some of these opinions are easier to formulate than others. Their complexity also depends on the target portfolio and benchmark given as well as the time horizon associated with active management.

FIVE CAPABILITIES FOR SUCCESS

Successful active management requires you to define

  1. the portfolio or benchmark against which you formulate opinions and a definition of your investment universe,
  2. a value proposition, that is, an investment philosophy, why your opinions will turn out to be correct most of the time,
  3. your uniqueness in formulating opinions and a process for doing so,
  4. of a process to manage the inherent uncertainty related to your opinions, and
  5. a cost efficient and error free process for transferring your opinions into portfolio positions.

Based on the existence of capabilities underlying these definitions, I confirm my initial answer to the question “Does active management make sense?” with yes under the assumptions that you possess them.

While doing so, remember the fundamental law of active management:

  • Many opinions are better than few opinions.
  • Correct opinions are better than incorrect ones.

LESSONS LEARNED

  • Successful active management is tightly related to success in formulating correct opinions about markets.
  • Successful active management depends on the selected reference portfolio or benchmark.
  • Successful active management requires sound execution capabilities.
  • Look out for flawed assumptions in philosophical discussions about active management.

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