Active, Passive and the Unknown

Actively managed investments are opportunity driven strategies.

Active, Passive and the Unknown

Actively managed investments are opportunity driven strategies.  Fund managers look to buy and sell securities in order to;

  1. Produce returns in excess of a nominated index for the investor, and
  2. Increase profits for themselves  (being their primary motive).

If they can achieve both of these, then everybody wins.  The manager will typically also capture a performance fee along the way and deploy their marketing resources to attract more investors into their product.

Just buying and holding securities makes them passive rather than active. When you research the so called active managers, the vast majority actually do no more than replicate the market index and charge a fee, thus providing a consistent under-performance.

If the manager can’t produce market out-performance, they will invariably have a good story as too why they haven’t and dig deep for data and research which will convince the client into holding the investments until they can be proven right.

This will have nothing to do with client time frames or goals, and much to do with client fund retention in perpetuity.  In the meantime, the manager will continue to get paid for under-performing their own targets.

Occasionally, some active fund managers have proven themselves to be better than others and better than passive markets (indexes) after taking into account their management and performance fees.

If they are able to sustain this out-performance over a period of time, and this out-performance is understandable, then full credit to them and they deserve further investigation as too whether or not they can be incorporated into investment portfolios.

These managers are a rare species, as a vast majority constantly (and over varying time frames) manage to underperform the passive indexes whilst still charging fees.

Their marketing skills are clearly superior to their management skills.

The risk with supporting superior management skills is that the particularly skilled individuals within the firm, and their closely linked teams of experts, can and often do change camps at very short notice.  They simply get drafted by another fund manager leaving your funds at a mercy of their replacements.

The other risk is the fact that most recorded and tested outperformance occurs in smaller and newly listed companies and business ventures. This is to be expected as deep research at the commencement of a business is far more likely to produce alpha (out performance) than just buying and selling large listed companies and trying to time the market.

The problem here is that as these small caps or emerging stocks become better known, they also become fully priced. Invariably it becomes more and more difficult to find new superstars in this limited market space.

This can lead to either an oversubscription of new investment capital, or a shortage of appropriate companies to invest in, which results in the manager holding large sums of cash, or taking greater risk with their selection process in order to be fully invested.

Either way, in order to gain true out performance one must take on additional and/or unknown risks.

Perhaps the greatest risk of all is the Fund Manager (The Superstar) Risk.  They can be secretive, ego driven and totally unpredictable.

In very recent times there have been instances of very odd fund manager behaviour which has left investors totally unprepared and stranded;

– A leading fund manager finalised a secretive deal with a very large institution to sell out his shares in the managed fund, off market. This resulted in a huge immediate market discount and uncertainty for the unit holders (investors).

– A well-known fund manager decided to close down the funds he was managing (in excess of $2 Billion) and return the money to investors.  His claim was that he was concerned with the future of the market.  As it turns out, he has a legal battle with his mum who happens to be a major investor.

– One of the most successful small cap fund managers had to restrict the inflow of new cash as the opportunities to invest were drying up. This will lead to panic and a freeze on redemption requests.

All three of these fund managers have been successful in outperforming their indexes. All three have now moved on to pursue their own financial and lifestyle objectives. The investors left behind are no longer their concern.

There is ample evidence of superior individual capabilities and skills in the crowded money management space. Unfortunately they present perhaps the greatest risk of all. They are too often unpredictable, contrarian and impulsive.