What are You Try to Solve For?

Consistent alpha generation has been the golden goose individuals and institutional investors have been searching for ever since people began hiring investment managers. Unless you were lucky to invest with Jim Simons, the endeavor has brought nothing but disappointment. When looking for an active manager, the criteria should include so much more than just potential alpha generation.

You are buying the process not the alpha

The goal of analyzing an investment manager is to understand their process, the potential opportunities that could be missed because of the process, the repeatability of success because of the process, and the ability of the manager to stay with the process through the market cycle.

Institutional investors have the ability to dig into an investment manger’s process through manager interviews, historical portfolio allocation and trading, and performance. They get a much clearer understanding of the manager and her process than an individual investor could. The individual is only able to see delayed quarterly holdings, performance, and a brief bio on the manager. This leads the individual having less conviction about the manager and can lead to performance chancing during times of underperformance of the manager. The institutional investor has the mental fortitude to withstand periods of underperformance because of the conviction that was developed during the investigation of a manager.

The lack of access to an investment manager should help the individual realize that investing in a cheap index fund is a more sustainable investment process. As Barry Ritholtz said, the best investment strategy is the one you are willing to stick with.

Efficiency of the Market

I have referenced this chart by Michael Mauboussin many times because I believe its shows why active managers in public markets are bleeding funds as investment managers in private markets are swimming in fund flows.

(Gavin Baker also had a great thread about this).

The more efficient the market, the less variability there is between managers, leading to luck playing a bigger role than skill (also known as the paradox of skill). If a market is efficient and cheap passive investment vehicles are available, does it make sense to allocate a significant amount of time trying to find the best manager in that market?

“In extreme cases, choosing a first quartile fixed income manager adds a meager 0.3% per annum relative to the median result. In contrast, the first quartile venture capitalist surpasses the median by 30.1% per annum, providing a much greater contribution to portfolio results.” – David Swensen, Pioneering Portfolio Management

Time is the most valuable asset any investor possesses. How that time is spent is of the utmost importance.

Cost

The efficiency of the market is also going to dictate the cost of active management. The increasing efficiency of U.S. public equities has allowed for the creation of passive investment vehicles that give investors the ability to access market exposure at a fraction of the cost of active management. This have been a major driver of active manager bringing down fees.

Private equity investment manager and venture capitalists are still able to charge high fees because the inefficiency of the markets, illiquidity, and lack of passive investment vehicle. Those managers still have to generate attractive returns to justify those fees, but it’s the inefficiency of their respective markets that allow for those types of returns required to justify the fee to exist.

Replication of the Benchmark

It’s important to look at the benchmark an investment manager is being measured against. There are times that the benchmark is not an accurate representation of the inefficiencies, risks, and opportunities an investment manager is trying to take advantage of. For example, Chinese companies usually dominate the benchmarks of emerging market investment managers. But an investment manager might not view China as an emerging market and she sees more opportunities in less developed nations. So many she is underperforming that benchmark, but it’s an apples to oranges comparison. It is then the job of the client to see if there is an investable benchmark that can be used for a better comparison. If not, then the additional cost of active management might be worth it to gain exposure to particular opportunities and risks.

This issue is especially present in fixed income. These benchmarks are going to be dominated by the largest issuers of debt. The inefficiency the fixed income manager is trying to exploit is probably difficult to replicate in a fixed income benchmark.

Exposure (paying for beta)

There are plenty of cheap ETFs out there if an investor wants exposure to a certain asset class, factor, sector, or macro theme. Paying active management fees for exposure alone is no longer justifiable.

The views expressed are my own. They have not been reviewed or approved by my employer. Nothing on this blog should be considered advice, or recommendations. If you have questions pertaining to your individual situation you should consult your financial advisor. Please read my disclosure page.