Making The Case For Active Management

The key to making the case for active management is to acknowledge at the outset that you are likely to underperform (potentially quite substantially) the markets over the long term. The reason for this is you are likely to sell either too early or too late into a market correction and are likely to either buy too early or too late after a recovery. Timing entries and exits to and from the markets is incredibly imprecise and highly inefficient from a long term investment management perspective.

That having been said, what you are advocating with active management is that you are going to try and reduce your downside by actively taking money off the table when you think the odds are in your favor. The basis for this activity is managing clients emotional wellbeing. The cost of this exercise is reduced upside because you know you are unlikely to time exits and entries perfectly.

You are offering clients the peace of mind of knowing and believing that they have someone out there trying to actively protect their assets. They are willing to forgo some upside because they are happy knowing/believing that the downside is somewhat capped.

A problem occurs when the manager fails to set a stop loss or floor and follows the market down. Usually because of their own behavioral foibles.

I don't think it is unreasonable advocating active management to clients who want to believe they have some semblance of downside protection and realize that it comes at the cost of upside potential.

The problem is clients want it both ways. They want downside protection and unlimited upside potential.

Other issues related to active management are overactive management, ie. chopping and changing market position repeatedly in response to news, and operating within a probability based framework.

Active management is a not unattractive framework for wealthy UHNW investors. The reason is they should want to earn a reasonable return on their wealth in order to preserve its purchasing power and derive a risk premium but they should also want to make sure they don't expose themselves to substantial capital destruction which can happen when markets collapse. Wealthy investors should be more focused on preserving their wealth as compared to growing their wealth. Whether they are or not depends upon the individual and their risk profile.

The irony is that wealthy investors often take more risk than they should because they are 'greedy' for returns. They think because they have been successful the markets somehow owe them greater returns. This is a dangerous trap that many fail to realize until it is too late. The irony is that they seek out active management not to protect their downside but to enhance their upside. And for the most part, they are likely to be sorely disappointed.

More On The Purpose and Role of Active Management

Most retirement plans offer a menu of index funds and active funds. The active funds typically comprise brand name, "institutional quality" managers. They are in essence a safe bet from a performance, business and career risk perspective. They will likely deliver somewhere between 1% outperformance to -2% underperformance (which incidentally is acceptable). They are the proverbial closet indexers. You may wonder what is their role. If they can't and aren't trying to generate genuine outperformance (alpha), then why use them. I think the reason is as alluded to previously (business, career and performance risk management) but also because they serve several other important purposes.

Namely, they provide the potential for outperformance (an important psychological factor). And they do provide some degree or potential of downside mitigation. Both of which meet the needs of most investors to believe that their fund is being managed by an expert and provides them with a positively skewed opportunity set.

Hard to know whether this is a cynical take on active managements role or simply the reality, which although it is unlikely to deliver alpha, actually does provide investors with a degree of comfort.

If plan providers were to offer "genuinely active" managers then the outcomes could be a real mess. The hit rate on finding and getting a genuinely active manager who then outperforms is pretty low. Not worth the risks and hassles associated with it.

Genuinely active = relatively new fund (less than 3 years old), concentrated bets, small amount of assets under management.