A Rationale For Active Management

Active managers are throwing in the towel. They haven't demonstrated an ability to beat the market and are now re-evaluating their value and their selling proposition to investors.

http://www.thinkadvisor.com/2015/04/06/the-real-point-of-active-investing 

I need to think about this some more. There may be a viable rationale to active management beyond trying to beat the market.

Do I want a plane flown only on auto pilot or do I want a plane piloted by a person who may be able to react in an emergency. The analogy may not work because there may be times when a plane flown by a person takes emergency action for no reason whatsoever.

Active Management - Don't Just Stand There, Do Something...Not!

Active management is predicated on the odds of making a good directional call, the conditional magnitude of the expected change in the markets, the proper sizing of the change in the portfolio to take advantage of that information edge and the timing of entry and exit from the portfolio repositioning.

Anytime the odds are against you, you should not be making any portfolio changes. There are times when the odds are in your favor, but the magnitude of the expected market change is not great enough to warrant changing portfolio position.  And there are times when the odds are in your favor, and the expected market change is sufficiently great to warrant altering portfolio position to take advantage of the potential opportunity. When that is the case, it is critical to stick the entry and exit.

Three things must be got right to benefit:

1. You must have some idea of the odds wrt market directionality (because you are dealing with the future, odds are entirely subjective...now you may have all sorts of historic-based or fancy forecasting models, but you need to also allow that the odds you perceive are out of whack). Odds are focused on market directionality and magnitude of market move. If you bet and get directionality wrong you are toast.
2. Odds on market directionality is hard enough to get right. But gauging the second leg of good active management calls, ie. magnitude of market move (assuming you got directionality right) is another crapshoot. Once again active managers have all sorts of tools, charts, and fancy models to help, but it is all guesswork. If you get the second leg of a good active call wrong, ie. the proportions of the market move, then you risk having made a portfolio change for only marginal gain, ie. limited benefit, and have incurred unnecessary transaction costs.
3. Assuming you are right about the directionality and the magnitude of a market move, you then need to get three additional elements right. The timing of repositioning the portfolio, the sizing of the repositioning to take advantage of your insights, and the timing of your exit from that position (which requires a whole new set of odds related to directionality and magnitude). This may in fact be the hardest part of portfolio management.*

Active management is tough. There are a lot of moving pieces and a lot of unknowns. You've got to get a lot right to gain from your insight.

* A recent study reported on in the latest AAII magazine pointed out the ability of stock pickers to pick stocks is pretty good. But they stink at all the other elements of portfolio management.

I'm Going To Mark This Spot For Active Management

With the release yesterday of Vanguard's funds performance relative to peers showing the pure dominance of passive over active management over whatever time frame you want to look at, I am going to put a marker in the ground, and as a good contrarian, say that marks the pinnacle of passive over active for this cycle.

I have no idea how long active vs passive relative performance cycles last, but if something can't go on forever, then it probably won't.

The irony of course is that I am launching a passive index based advisory practice just as active is likely to see a turnaround in its fortunes.

The other giveaway to the "peak passive" theory is the increasing crescendo of headlines touting the fact.

Oh well, back to basics. The principles of investing are simple. The act of investing is hard.

Getting Ahead in Traffic - An Analogy for Active and Passive Investing

Heather recently shared a great analogy between changing lanes in traffic and active and passive management.

In the same way that active management seeks to get ahead (beat the index), lane changers are trying to get ahead in traffic.

In the same way that studies have shown that those who stay in their lanes finish ahead of those who are always jostling for position, studies have also shown that those who stick to passive index funds typically do better than the average investor over the long term. 

Just as active management incurs lots of costs, so to trying to get ahead in traffic incurs lots of costs (psychological, emotional, physical).

The different speeds of the various lanes encourages drivers to jump from one lane to the next. Sounds familiar, as when investors use hindsight bias to jump into the latest investment craze.