Active Portfolio Management

The Ultimate Investor

Active Portfolio Management (posted 27 Feb 99)

Is it possible to outperform the market? This is one of the most important questions any investor should ask. If your answer is no, if you believe the market is efficient, then passive investing or indexing - buying diversified portfolios of all the securities in an asset class - is probably the way to go. The arguments for such an approach include reduced costs, tax efficiency and the fact that, historically, passive funds have outperformed the majority of active funds (see MARKET EFFICIENCY and INDEXING).

But if your answer is yes, it is possible to beat the market, then you should pursue active portfolio management. Among the arguments for this approach are the possibility that there are a variety of anomalies in securities markets that can be exploited to outperform passive investments (see INVESTOR PSYCHOLOGY), the likelihood that some companies can be pressured by investors to improve their performance (see CORPORATE GOVERNANCE), and the fact that many investors and managers have outperformed passive investing for long periods of time.

But the active investor must still face the challenge of outperforming a passive strategy. Essentially, there are two sets of decisions. The first is asset allocation, where you carve up your portfolio into different proportions of equities, bonds and other instruments (see GLOBAL INVESTING and INVESTMENT POLICY). These decisions, often referred to as market timing as investors try to reallocate between equities and bonds (see FIXED INCOME) in response to their expectations of better relative returns in the two markets, tend to require macro forecasts of broad-based market movements (see ECONOMIC FORECASTING and POLITICS AND INVESTING). Then there is security selection - picking particular stocks or bonds. These decisions require micro forecasts of individual securities underpriced by the market and hence offering the opportunity for better than average returns.

Active investing involves being 'overweight' in securities and sectors that you believe to be undervalued and 'underweight' in assets you believe to be overvalued. Buying a stock, for example, is effectively an active investment that can be measured against the performance of the overall market (see PERFORMANCE MEASUREMENT). Compared to passive investing in a stock index, buying an individual stock combines an asset allocation to stocks and an active investment in that stock in the belief that it will outperform the stock index.

In both market timing and security selection decisions, investors may use either technical or fundamental analysis (see TECHNICAL ANALYSIS, VALUE INVESTING and GROWTH INVESTING). And you can be right in your asset allocation and wrong in your active security selection and vice versa. It is still possible that an investor who makes a mistake in asset allocation, perhaps by being light in equities in a bull market, can still do well by picking a few great stocks.

There are arguments for both active and passive investing though it is probably the case that a larger percentage of institutional investors invest passively than do individual investors. Of course, the active versus passive decision does not have to be a strictly either/or choice. One common investment strategy is to invest passively in markets you consider to be efficient and actively in markets you consider less efficient. Investors can also combine the two by investing part of a portfolio passively and another part actively.

Guru of active portfolio management: Bill Miller

It is hard to be the best performing manager for the past five years out of a field of more than five hundred. Not just that it is so difficult to be there - and it is - but also difficult to maintain one's mental balance. The temptation is to be too cocky and believe the publicity one receives. Or one could become too concerned with the inevitable stumble that lies ahead: old Bill has just lost it, some will say.

One way Bill Miller of Legg Mason's Value Trust keeps his head is to stress the intellectual side of investment. And he concentrates his investment attention so that extraneous contemporary PR does not distract him. His job is to outperform and every instinct he has is brought to bear on that objective. Over and over, he can repeat his lessons from profits and losses. His shareholders' glories and pains are his own. He takes the lessons, structures them into principles and keeps improving.

Miller is rather liberal in defining the details of his tactics when it suits him. He is not bothered by people who say that Czech bonds, for example, or go-go tech stocks trading at sky-high price-to-earnings ratios are not value investments: if they go up, they were and that is what counts. The definitional straitjackets of others are their problems, not his.

Miller is reaching out to complexity and the Santa Fe Institute, where he is a trustee and has a house, to teach him how to break today's investment bronco. Few others have the patience to deal with the ambiguities inherent in any emerging science. And it lets him contemplate the future of investment styles with a catholic perspective, a dogged determination to triumph and in the company of physicists ready to humble anyone wasting a good mind on one of the soft sciences, for money.

Counterpoint

Nobel Laureate Bill Sharpe makes a simple yet powerful case against active management in his article 'The Arithmetic of Active Management': 'If active and passive management styles are defined in sensible ways, it must be the case that: (1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar; and (2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.'

Sharpe continues: 'This need not be taken as a counsel of despair. It is perfectly possible for some active managers to beat their passive brethren, even after costs. Such managers must, of course, manage a minority share of the actively managed dollars within the market in question. It is also possible for an investor (such as a pension fund) to choose a set of active managers that, collectively, provides a total return better than that of a passive alternative, even after costs. Not all the managers in the set have to beat their passive counterparts, only those managing a majority of the investor's actively managed funds.'

Rex Sinquefield of Dimensional Fund Advisors is more brutal. He says there are three classes of people who do not believe that markets work: the Cubans, the North Koreans and active managers.

Yet investment managers are competing hard to manage institutional and individual investors' money and it is not surprising that they make claims about their market-beating potential - usually using active strategies - and, where possible, their market-beating performance records. And social norms of prudence, investor anxiety and anticipation of regret over flawed decisions contribute strongly to the demand for supposed financial expertise. Of course, if you believe in active investing, it is best not to judge a manager by their past performance indicators but rather by the plans by which they expect to add value through outperformance.

Ambitious investors and investment managers almost all want to beat the market, but it is worth asking why should they want to beat it for you. Why should precious insights into the nature of the market be available for sale to the general public, either directly through a fund or indirectly, perhaps through a book advocating a particular investment technique as the route to outperformance? If an investment technique is so good, it would seem to make more sense to keep its secrets to yourself.

It does seem to be the case that an investor who tries to predict short-term changes in share prices has to be right about 70% of the time to beat the market. Peter Jeffreys of S&P Fund Research, a London fund-rating company, has screened 4,800 funds since 1982 to see if past winners repeat their success in the future. He finds that the probability of that comes down to 'almost pure random chance': using three year rolling average performance as a measure, it turns out that of funds that beat the average six years running, only just over a half did so the next year.

[Guru response, if any]

I think the on-line market is like the discount business--it just further segments the market; it doesn't replace traditional trading or brokerage. Sort of like TV to the movies, then VCR's etc. On-line traders are most like traditional discount customers, which is why Schwab is so successful at it. The do-it-yourself market is big and growing in a lot of industries, but it rarely if ever totally displaces those who want to pay for service and advice. This is different from, say, book retailing, where the best customers of Borders are the best potential customers of Amazon. The best brokerage customers, equity oriented wealthy families who use margin are not the profile of the E-trade customer, whose demographics are entirely different. They may merge in a generation or so, but by then only the most dim witted brokers will not have been able to adapt.

Where next?

The latest research in financial economics seems to confirm that markets are not strictly efficient and that there are 'pockets of predictability'. This offers some hope to 'disciplined' active managers if they can come up with innovative techniques to achieve superior long-term returns (see FINANCIAL ENGINEERING).

But it is very important for any investor to watch closely for changing market drivers. For example, the market drivers until late 1998 were easy credit, moderating inflation, lower interest rates, rising earnings and the wide publicity of a sixteen year bull market in equities - by some counts, a fifty year bull market. The 1990s have seen a 16% compounded rate of growth for equities versus 6% historically, so it is not surprising that strong momentum keeps everyone in the game.

But we are beginning to face a different set of market drivers and it is hard to tell where they will drive us. The kind of financial concerns we face are rather novel in all of our lifetimes. There is illiquidity; wealth has been destroyed in many parts of the world; and inflation has turned to disinflation, to lower inflation and now to deflation. Deflation is destructive, especially for debt, which has led to a quality preference on debt where only the highest quality can pass muster and the ability to borrow is probably the only thing that counts in analyzing securities (see VALUE INVESTING).

What about the impact of news on portfolio management decisions? It is worth noting that precisely the same evidence may be used to support a good market tone or a bad market tone - a bull market or a bear market. For example, the absence of rising prices could be good for continued growth and low unemployment, or it could be bad because deflationary forces are building up and, as the experience of Japan indicates, they are extremely destabilizing. Interest rates are attractive for borrowing and money is plentiful, which is very good for business; but it may well be bad because it means that a great deal of money is flowing in from overseas to the United States as the last fortress of capital.

Similarly, the public continues to buy IPOs (see INITIAL PUBLIC OFFERINGS), almost every single one. Is that good because it means confidence or bad because it means that there is such a strong psychological undertone to the market that when it cracks, nothing will bring it back? What is more, we have got the quality stocks doing much better for the last several years than the broad market averages. Good because it suggests leadership? Or bad, meaning that there really is a low level of confidence, and this is just speculation in well-known names?

Also, we have continued concerns about what will happen in the year 2000 with our computer systems. Good - if nothing happens - or bad - because the year 2000 is only months away? Finally, earnings are good, but on the other hand, the majority of the surprises are on the downside: there appears to be a deterioration in terms of buildup of disappointments. So the same news can be seen as good or bad.

Read on

In print

Roger Ibbotson and Rex Sinquefield, Stocks, Bills, Bonds, and Inflation
Doug Henwood, Wall Street: How it Works and for Whom
Bill Sharpe, 'The Arithmetic of Active Management', Financial Analysts' Journal, 1991
Romesh Vaitilingam, The Financial Times Guide to Using the Financial Pages

Online

www.santafe.edu - website of the Santa Fe Institute

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