Friday, December 18, 2020

Does Active Investing Work in Theory?

We know active investing almost always doesn't work in practiceThe vast majority of professional money managers underperform their respective index over meaningful periods of time. Let that sink in. Compared to what we could easily do on our own through indexing, most of the people we pay very large sums to invest our money give us back less after they do their job and take their fee. For those few that do, we say they earn alpha--return in excess of the market for the same level of risk taken. 

As a side note realize something. Your Uncle Fred with all the great stock picks or your friend who just quit his job to start day trading and who has actually has been making money trading stocks, bonds, options, or whatever HAS NOT been taking the same level of risk as any index. Those two happen to be winners in a likely random pool of many people taking on tremendously more risk than they realize. If 10,000 people all flip coins ten times in a row, some of them almost certainly will get ten heads in a row (singularly by itself a 1 in 1,024 chance). 

However, I am focused on professionals here. Guys and gals who dress sharp, use all the right jargon, are actually highly intelligent and reasonable, and who most of the time lose money for their clients. Perhaps their clients are buying something else than returns [paging Robin Hanson--investing professionally isn't about making money]. Highly likely in many cases. It feels good to deal with these pros. Plus they can in fact help investors stay disciplined--better to make 5% versus the benchmark's 6% over 10 years than to bail out when the market declines and earn only 1% over that same 10 years. Fortunately for EMH and unfortunately for this theory, this affect has been shrinking to recently be nearly nothing.

So, while active management doesn't work in practice, does it work in theory? Start with the assumption of a manager that can consistently and reliably earn 1% alpha. When her benchmark is up 6%, she is up 7% on average. Why does she need your money? 

I can think of two likely reasons:
  1. She could want to use it to reduce her own risk. 
  2. She could have more opportunity than she can herself realize.
Notice that these are not altruistic motivations. The first is fairly unfavorable for the client--you are giving her money not for your benefit but for hers. She uses the additional funds to smooth out the volatility in her own income. When you pay a management fee to her, you are directly subsidizing her income. And just the use of the funds themselves is an indirect subsidy allowing her to invest more broadly. All of this might be justified if the second reason holds.

In the second she only would invest your money once she has invested all of her own money including all the money she can borrow at less than the total return of the investment, which is the market return plus alpha (6% plus the 1% in this case). Theoretically and in practice she will charge you a small fee to cover transaction cost plus a little profit to her to let you participate in her investing endeavors. Yet as we saw in the first reason she should probably be paying you as you are giving her a benefit of lower risk in the form of a smoother income stream.

Essentially this is an arbitrage which we know is going to have a limited capacity. Even if she is in that elite company of professionals who can outperform the market, her last idea (say the last stock her analysis says to buy) will be her worst idea and only be at best just as good as the market itself. It seems very likely by the time she gets to your money, we are firmly in reason-one (personal risk reduction) territory. 

This is quite damning for professional money management--in theory. What might save it and asset managers like myself who do in fact invest client money with money managers? 

First, we must admit just how challenging it is to find professionals who can outperform the market. Second, we must consider that the first reason above, income-smoothing risk reduction, might actually have a win-win aspect to it. Yes, she does enjoy less risk by using your money, but she doesn't get this for free. In fact she is probably risk averse enough that the second reason doesn't hold firmly.

Rather than fully lever all of her available resources--put her risk at ludicrous speed--she would likely prefer giving you most all of the risk of her performance and collect a steady fee for doing so. She is giving up the potential for return upside so that she has only very little downside risk. This flips the concern from being a pure doesn't-work-in-theory problem to being a pure principal-agent problem. sigh We can't catch a break. Now we have to worry that she isn't incentivized properly to continue to do what we hope she can do--outperform the market at the same level of risk. But at least we partially rescued active management in theory.

As bad as this is (in theory), this is in public market active management. The same forces are at play plaguing private markets like private equity and private debt. At least public markets are not opaque, very hard to benchmark, illiquid, et al.

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