A different perspective on alpha
Updated: Jul 25, 2021
By Martyn Wild.
Eyes on the prize We need to get something off our chest: we believe in both active and passive management! No, we aren’t hedging our bets, it’s just years of experience and a little bit of arithmetic. Before we tackle the active v passive debate head-on, let's make sure we recall what we are trying to achieve from first principles.
Portfolio construction should be all about risk minimisation – or “certainty maximisation” as we prefer to refer to it – when targeting a specific return objective. To maximise the certainty of achieving the target return on average, it follows that we would invest our capital in the combination of assets with the highest probability of achieving that target return. Invariably, this entails mixing assets just so, so as to reduce risk at a greater rate than the return we may lose by adding assets with a lower expected return. The more that assets are uncorrelated, the greater the reduction in portfolio risk from combining them: that's diversification, pure and simple.
It therefore follows that if active management can be a source of uncorrelated returns (and we think that it can be), it should be a candidate for inclusion in our portfolio. So, we think that rather than the question being ‘why should we choose active managers?’, the real question is ‘how should we choose active managers?’.
Don’t make it harder than it needs to be
Of course, precisely how much active management is appropriate is beyond the scope of a simple blog like this. Nevertheless, we can supply a basic framework at least. In our article, ‘Take it Easy…’, we demonstrated the power of time to increase outcome certainty. Not only does this theory work for whole asset classes, it works for any stream of returns; including active management. We advocate that the time-horizon, like the asset allocation, should be tailored to each client’s unique requirements.
As it relates to how much active management to use, it follows from the paragraph above that this is a function of time horizon; more clearly, when the diversifying effect of time becomes meaningful. We suggest ‘meaningful’ begins around the 5-year mark. Use of active management is also clearly a function of the availability of good managers: if you can't source managers with skill in beating the market, avoid them at all costs. The corollary is also true - hold on to the gems with all your might!
A common-sense plan for ‘going active’ (or not)
Try this as a basic decision framework for using active management: start passive and progressively add active management if your time horizon is genuinely 5 years or more and you are skilled in finding managers that can fulfil their promises.
Now of course, reality isn’t quite this straightforward. Nevertheless, if you can’t pick good active managers and/or can’t give them at least five years or more to do their thing, then active management shouldn’t be your focus. Instead, focus on exploiting other areas of value-add such as portfolio construction or implementation efficiency.
Forge a different path
We believe that the active/passive choice comes down to your ability to identify managers with a genuine ability to consistently outperforming markets and the suitability of your portfolio to accept them. Where we go further is that it is also time period specific choice as well. Utilising active managers is a great idea, so long as you give them enough time for their skill to come to the fore - even great active managers have a run of bad luck. If, like many investors, you cannot wait that long then a bias to passive investing is most likely to be your best bet. Excuse the irony.
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MARQAM is a privately-owned, boutique consulting company focused on providing superior investment outcomes for clients and greater profitability for businesses. We are not affiliated with any other financial institution
Disclaimer: The information provided here is for interest purposes only and does not constitute investment advice or a recommendation of any kind.