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“Nobody is going to save you but yourself and the best and only way to do so is through action.” – Oli Anderson[1]

Active management is tough business. Alpha-generating strategies can lose their luster in a quarter or two, helping to explain why 80% of active funds underperform each year. The challenges facing active management – particularly the competitive threat of passive products – have never been greater. In response, traditional investment management companies have launched a host of initiatives to fortify their businesses: creating custom portfolios to match unique client requirements, establishing their own index and ETF offerings and revamping marketing/customer relationship services. Less frequently observed are concerted efforts directed at improving fund management skills, processes and ultimately performance (not improvement as an aspirational goal as it is generally approached, but improving deliberately using rigorous feedback and a scientific method).

Passive Investing
3112014 / Pixabay
Passive Investing

This article takes a hard-nosed look at the pummeling being taken by active management and argues that improving can no longer be approached passively. It must become a core competency for every active manager.

The index tsunami

The global shift in assets away from active to passive products, while already substantial, is about to hit its full stride, according to Moody’s Investor Services. In a recent report[2], they stated: “Passive investments – ETFs and index funds – account for $6 trillion of global assets. Now 28.5% of assets under management (AUM) in the US, their US market share is rapidly expanding, driven by lower cost and better performance relative to actively managed funds.” Moody’s went on to project that within the U.S. passively managed assets will exceed those actively managed sometime between 2021 and 2024. They further estimated that while 5%-15% of assets in Europe and Asia are managed passively today, we should expect this proportion to grow significantly in the near-term.

Moody’s believes this capital reallocation reflects, in large part, investors reassessing their options: “The main driver of flows out of active funds into passive funds has been investors’ growing awareness that, by definition, actively managed investments, in aggregate, cannot deliver above average performance, and that investing is therefore a zero-sum game – for every winner, there must be a loser(s).” An additional driver cited is changing regulations: “Passive investments’ expansion has been further supported by global financial regulation, which has encouraged greater disclosures of fund fees and potential conflicts of interest.” The report added: “In practice, it will become more difficult for advisors to place their clients into higher cost and more complex investment products.” The report concluded: “Selling low-fee index products, on the other hand, will eliminate many apparent conflicts of interests and minimize an advisor’s fiduciary risk.”

Structural shortcomings

Active management is ill-equipped to achieve meaningful improvement due to the heavy dependence upon folklore and poor feedback to support learning. Expressions of folklore routinely include aphorisms such as:

  • it is a good sell as long as the proceeds are reinvested in a winning buy;
  • growth managers are more likely to exhibit the endowment effect; and
  • managers that beat their benchmarks do so primarily by purchasing great names.

Comforting as these and other investment truisms feel they are often wrong, as borne out by Cabot’s analysis of more than $2 trillion of professionally managed assets.[3] Reliance on such pseudo-facts gives individuals a false sense of their own strengths and shortcomings, making it near-impossible to improve.

Poor feedback is what inhibits self-awareness and improving. What type of feedback specifically?

All of it!

Conventional metrics such as relative return, information ratio, tracking error, alpha, attribution analysis and hit rates are merely scorecards. They provide useful information about past performance yet they say nothing about the manager’s strengths and weaknesses.[4] Most importantly, they cannot guide the manager to the one thing she should do today to become a better investor tomorrow. Improving requires facts not hunches, and needs to be driven by rigorous analytics, not emotionally laden recollections or reliance on comforting narratives.

By Michael A. Ervolini, read the full article here.