Active management in a passive world

Active management in a passive world
AnandKZ / Pixabay

Active management in a passive world  By Rocco Pellegrinelli, CEO, Trendrating

It’s a difficult time to be an active manager: according to S&P data, 83% of US and 86% of European equity funds underperformed their benchmarks over the last decade. In parallel with this underperformance, index-tracking funds are enjoying a moment in the sun: they already account for 40% of the $9tn U.S. market in equity mutual funds and exchange-traded funds (ETFs). The allure of uncertain – but potentially high – returns is slowly diminishing in favor of more assured (if lower) profits.

No fund manager actively sets out to underperform, and many will be as frustrated by the last ten years as their investors. Nonetheless, there is a widespread perception that they aren’t justifying their pay. Fees and bonuses often aren’t tied to performance, so if a fund doesn’t beat its benchmark by a certain margin, investors can end up worse off than they were before.

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Active Management

If the process of selective stock picking is to survive in an age of passive management, it needs to evolve into a more evidence-based, technologically-driven strategy– one that filters out human stubbornness and ego as much as possible.

This doesn’t mean abandoning everything you’ve ever known to rely on computers and algorithms. The fundamentals can remain intact. But better decisions are made with the best information – and adopting a more systematic approach can provide fund managers with the best information. You just have to be willing to take the necessary steps and adopt the required technology.

active fund managers – Analyze this?

Step one: limit the influence of your analysts, or get rid of them entirely. Highly-paid researchers offer unparalleled insights into the movements of the market, but in reality, they often fail to live up to this promise. They reverse-engineer predictions after significant events, giving them the illusion of peerless foresight – a habit that makes them look like Nostradamus while conveniently relieving them of any need to make accurate forecasts.

Despite this, fund managers tend to defer to their opinions when making critical investment decisions. This is by no means the only reason for underperformance, but it certainly doesn’t help: it renders them susceptible to their own biases and flaws, and the biases and flaws of their analyst.

The blunt truth of the matter is that, even if analysts work as advertised, they aren’t strictly necessary. You don’t need to know why the ocean is blue to go for a swim, and you don’t need to know why stocks are moving to take action. The fact that the stock is moving is enough: the role of analytics is to help you discern price direction.

You can still actively select stocks – but you should know which way the wind is blowing before you do.

active fund managers – Outlook not so good

The magic 8-ball approach to stock-picking isn’t limited to analysts. The efficient market hypothesis has taken something of a beating in recent years, as companies launch IPOs at valuations that are completely divorced from reality. Often – and particularly with hyped technology companies – their price is completely divorced from reality: Twitter has never been close to profitability, but at its peak, it was valued at over $17bn.

But even outside of the tech sector, a company’s share price is no longer strictly associated with return on assets or cashflow. Even if a stock has excellent fundamentals and looks to be a solid immediate investment, you have to bank on other investors recognizing this – and that process can take several quarters.

As a value investor, you need the ability to invest in promising companies. But that’s a long-term process, and profits are often required in the near-term. By using momentum models you can gain insight into the real underlying price action, and back up your more educated guesses with hard evidence – giving you significant returns without forcing you to wait for your forecasts to come true.

active fund managers – Adjust your behavior

Of course, curtailing preferences is only one part of the process. Consider, for example, the disposition effect: a phenomenon where an investor or fund manager is simultaneously too eager to realise their gains and too reluctant to accept their losses. They hold on to losing stocks for far too long, and they sell their winners well in advance of their peak value.

You can counteract this by using a multi-factor investment strategy that tracks real price movement – allowing you to buy and sell at the ideal time. This will make it far easier to capture alpha, and reduce your dependence on guesswork and dubious ‘expert’ help’. For example, a multi-factor momentum and value strategy has a notably higher Sharpe ratio and reduces portfolio volatility. The best way of executing such a strategy is  through a systematic, technologically-driven approach.

When active investors can increase the accuracy of their stock selection and the reliability of their returns, everyone benefits – especially if incentives are tied to performance. Active management ultimately offers the best chance of high returns – it’s time this potential was realized.

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