Evaluating the Value of Active Management
The never ending debate about the merits of active investment management vs passive investment management rages on. In a post this morning Josh Brown asked this important question:
“How do we determine the “value” of active management?”
I think there are two primary characteristics that define how valuable an active manager is. The first is strategy value. The second is alpha value.
Strategy value is a money manager’s ability to add value through unique portfolio composition. The investment world is increasingly interconnected and blended by various approaches. The product line that Wall Street has produced over the years has become increasingly diverse and makes the options for portfolio construction that much broader. This is valuable in that we are then able to construct portfolios with varying correlations, risk levels and goals without having to be experts in specific individual security types or through having access to certain markets (which can be difficult in some cases). Importantly, we are no longer boxed in by our portfolio options that force us to pick one asset class or one strategy.
Unfortunately, most active managers mimic or copy a large correlated index of some type. There’s zero value add in this approach in most cases. After taxes and fees a similarly correlated index will outperform these strategies because they’re essentially the summation of the index they’re copying. By definition, they must underperform.
But there’s huge value in an approach that gives investors access to something that they can’t otherwise access through a broadly distributed index fund. I used to use an event driven strategy when I ran my investment partnership. I generated sizable risk adjusted returns with no negative full year returns during a 7 year period (in one of the most difficult environments in investment history). If there had been an index that replicated my strategy I would have had a hard time outperforming it. But there wasn’t (isn’t). So my value add was through my approach. I was giving my investors access to a unique strategy that helped them diversify their own portfolios through strategy value.
Of course, the strategy has to be valuable itself. This is where alpha value comes in. Alpha value is the ability of an active manager to generate high risk adjusted returns through their approach. Most active managers can’t generate alpha because their approach is essentially some form of closet indexing. In other words, large cap value funds don’t generate alpha because they tend to just copy the S&P 500. Their risk adjusted returns are weak and even weaker after taxes and fees. The average investor doesn’t even begin to study the importance of this when picking funds or managers. And the managers don’t want you to understand it because they want you to think that their fund is better regardless of a fair apples to apples comparison. How else could they justify the higher fee?
Of course, the key here is actually finding the active managers who can add value in one of these two ways over long periods of time. Easier said than done, but they’re out there.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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33 Comments
Hey CR, you should do a reddit AMA on MMR & the Platinum Coin…
Can you just set-up a AMA on your own? I thought you had to be invited?
Any resources on where we can find active manager that add value?
Well I think you are preaching to the choir. If I still had someone managing my money I wouldn’t be reading on the economy and markets
You should use Orcam to rate funds. Show Morningstar how to do it. Actually add value for people.
That’s a huge amount of work. Not in this lifetime I don’t think.
Readers, let me know if you know of a better diversified mutual fund over the last 5 years that included the 2008 crisis. My candidate fund is: PIMCO All Asset All Authority A (tickers:PAUAX or PAUDX).
The latest annualized returns for 1, 3 and 5 years are:
1 yr 16.0%, 3 yrs 9.5%, and 5 yrs 7.5% annualized. It is an actively managed asset allocation fund managed by Rob Arnott. The expense ratio for the D shares that I own is a high 1.58%, but I think it is worth it. The 5 yr standard deviation is 11.26. I also like VWINX, but that is more like a shadow index balanced fund. It is actively managed but does not change much. Its 1/3/5 yr performance: 10.4%-1yr, 10.05% 3yr, and 7.12% for 5 yrs.
What is their typical asset mix?
@Geoff, PAUDX (& pauax) have a very high percent in bonds, but a fairly high percent of the bonds are either domestic high yield or emerging market bonds with high yields. It plays into PIMCO’s strengths which is the evaluation & selection of strong HY and EM bonds. Has a small allocation to equities. Also it uses leverage to get higher returns on the bonds. The leverage did not blow up in the 2008 crisis, which it weathered fairly well.
Cool, thanks. Sounds like the fund has a very high degree of credit exposure (both EM and HY) as opposed to bond exposure. There’s a big diifference. Nothing wrong with credit exposure per se, but I would not exactly call the fund diversified. I’d also be a little concerned at how far credit has run. Some have called the current environment a credit bubble. I’m not sure I’d go that far. In any event, from what you said, it sounds like the fund did OK the last time credit crashed.
Also, Emerging Market bond investing requires a fine understanding of different sovereign monetary systems, which Bill Gross clearly lacks.
This was an awesome discussion.
The key danger for an investor is the spending equation which is very difficult to quantify on a risk basis – the risk that you will run out of money at some point in the future. This is the permanent loss of principal that Anonymous is describing.
At Bernstein we called it “risk drag” – spending from a portfolio during a period of market declines. Money spent from a portfolio during a decline suffers a permanent loss of future investment value. It is much more difficult to ride out the swings in the investment universe when you are spending at a high level from your portfolio.
Bernstein did numerous backward looking portfolio constructions using actual data that concluded that anyone spending more than 4% of the value from their portfolio has the risk of running out of money during their lifetime. This assumes that you have somewhere in the range of 60/40 mix of stocks and bond like assets.
Rather than reaching for yield, the best returns may come from finding ways to reduce your “burn rate”. Money not spent is capital that can stay invested.
This is a truly horrible time to be a yield based investor.
Which of these mutual fund measures make more sense to use? Alpha, beta, standard deviation, Sharpe ratio, or all of them in some combination?
There is no alpha without the concept of beta, and there is no sharpe without standard deviation (bc confidence intervals need sd to be computed). All however have no bearing on the concept of risk.
You sound like you know what you’re talking about. Can you elaborate? How would you best measure performance, alpha, beta, & risk?
Metrics like sharpe are only used bc ppl have a need to quantify things, but risk can never be (esp not using Gaussian curves). It’s become industry standard just bc of this psychological need- it just makes people feel better if they can point to a number or probability.
The qantifiable aspects of risk are few; sure price volatility is a risk, esp when you are nearing retirement or have an expenditure (although if either was the case, you should be in cash), but there are possibly hundreds of other sources of risk, the number, degree and relationship between vary depending on the security, the environment and the investors profile.
Risk is te potential for permanent loss of captial, and the only way to assess this is through an understanding of investment philosophy and ability to probabilistically value investments on a case-by-case basis. No more, no less.
Put simply, you will never be able to assess permenant loss of capital quantitatively. So if you can’t analyze the investments a manager makes (through philosophy and valuation), you won’t be able to access whether they are good managers. Even past performance says little; a good investment isn’t good bc it made money, and it isnt bad merely bc it lost money, and a track record can only be assesed over decades (and by then it could be too late) So for 99.999% of people, you choose the philosophy you believe to true and you choose character of the manager.
I know all that is of little help.
@Anon, you said: “esp when you are nearing retirement or have an expenditure (although if either was the case, you should be in cash), “.
I am in early retirement. If I were 100% in cash, then I would have no income stream. With hopefully at least 20 yrs to live, why should I be in cash? Are we on the edge of another crisis which means capital preservation at all costs?
I meant retirement thinking that there would be a greater need to spend on a moments notice. The issue in this environment is that it’s forcing people like yourself to reach for yield, ignoring the risk of principal. And that’s also ignoring “real”, ie not nominal rates of return. For someone in your situation, you are forced- by your profile and the investment environment- to take risks you can’t afford. The only edge you have is if your money is truly long-term, but that can mean 10-20 years, even more. You are undoubtedly between a rock and a hard place: you need yield, but that yield will most likely not keep up with prices, while simultaneously putting the principal you are using to get that yield at potentially severe risk.
Personally, I have more cash than I know what to do with- I have for over two years, but I deploy it judiciously in investments where permenant loss of capital is low and where near-term catalysts allow me to a manage my investment horizon. There are few long-term investments (ie no catalysts- example HPQ or JCP) I have made for years.
Putting money to work now and/or being fully invested in a situation like yours is risking permenant loss in this environment, but I understand your need/desire for an income stream. Again, rock and hard place. Right now, I value the optionality of cash, and I HOPE there is a time to investment is wisely with large margins of safety. But then again, I have experience valuing securities across many asset classes, so I can judge the risk/reward of investments, with the understanding that many investments cannot be valued.
One more thing- no one knows what the future holds, especially in markets, so don’t get riled up in terms of crisis, no crisis, etc. Just maintain the one thing you can control- keeping productive skills sharp and opportunities to utilize them open. You never know when you’ll need both.
With that said, congratulations on retirement. I’m headed back to the weekend and the hole from which I came.
@Anonymous, Thank you for your thoughts. Good luck to you, also.
I always look to see how a fund performed in the year 2008 to get a sense of how risky and volatile it is. Of course, if there is a new manager who has a different approach than the manager during 2008, then all bets are off. Looking at 2000 thru 2002 is also useful if you have a long-term fund manager at the helm.
Hi, while @anon is write about the problems with risk measurement , I think alpha beta and sharpe all three are important from the perspective of relative performance, and in the realm of relative performance the exact quantification of risk is not required.
Sortino is the only one I use, but even that has its flaws. As others have noted risk is more than just beta.
Sortino is same idea using semi variance and a target. Same usefulness. No relation to “true” risk or value-added return
I don’t totally agree with the notion that volatility is not risk. I think there is some truth to it. The true problem in portfolio construction is what I call the intertemporal conundrum. It is the problem of time within a savings portfolio. Ie, how do you allocate your savings in a manner that produces a sufficiently high risk adjusted return in accordance with protection against purchasing power loss and permanent loss. And more importantly, will that savings be there when you most need it. This understanding requires an understanding of volatility to some degree because we can measure within some level where certain asset classes are likely to be in 20 or 30 years. But the important point is constructing a portfolio that does not have unequal odds of being substantially below these performance estimates at time of arrival (ie, when you need your savings). Obviously, there are many ways to measure the risks that could do that, but volatility is one of them.
Sortino is just a way to more accurately gauge whether a strategy is going to get you there with a high degree of volatility or low. It’s not an all encompassing view of risk, but it’s an important piece of the piece. Far better than Sharpe ratio, that’s for sure.
Cullen, what source do you use to find the Sortino for a given security? Thanks
I calculate it internally. Not sure you can find it online….
Agreed. I would argue that sortino or similar measures is te wrong way gauge “inter temporal risk” as you say. The more substantive and reliable way is understanding valuation and catalysts to realize that value. If I hold cash in a portfolio, it’s due to the lack of investments with margin of safety, which catalysts contribute to, particularly in terms of time value. We are approaching the same problem at its core, but from different angles. I only fear using (or have others using) such measures like sharpe or sortino bc its only value IMO is being a false sense of security. Risk- from a price, earnings or balance sheet perspective- in addition to a myriad of others (including vol), is just an entirely different thing altogether.
Nice. Thanks for that.
And you can use omega too!
To Boston Larry: a 2011 recent book by Emanuel Derman titled Models. Behaving.Badly. has a very accessible discussion of the various types of risk, in addition to personal reminiscences, philosophy and clearly explaining why the entire Greek alphabet of factors and financial modeling will never be able to predict future performance of an investment… Sad, but true.
There is no such thing as passive investing. If you’re not making an active decision at the security selection level, you’re making it at the asset allocation level. Choosing to own “the market” is an active decision because you could easily have decided to not own the market.
“Passive investing” or indexing serves the interest of sales organizations which have an incentive to put their clients in a set it and forget it portfolio so that they can focus on accumulating standing pools of capital. Indexing gives the added benefit of being just good enough to keep clients and always gives the opportunity for the advisor/sales organization to deflect criticism for poor investment performance. By owning the market an advisor can always plausibly argue that losses were out of his/her control.
Active managers sell the fantasy that everyone can beat the market.