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.

Taking Another Shot At Market Efficiency

The market is inefficient.

What I mean by this is that the market is always in a state of controlled chaos. Some may consider this equilibria, but it is equilibria in a very limited sense of the word. Equilibria is not the same as intrinsic or fundamental value (which is also in the eye of the beholder).

Because market prices are a function of consensus feelings, emotions, expectations and sentiment regarding earnings, interest rates, risk and the future (in other words they reflect the current zeitgeist of the day and embed some feelings for the future), they are necessarily wrong all the time. No one knows what the future holds. Of course as markets correct and swing from overvalued to undervalued and vice versa, they must by definition pass through some median or fair value point. The problem is they rarely trade at the fair value point for any steady state period of time.

Getting cyclical trend and momentum right are consequently the most important ingredients to long term active investing, while have a mean reversion contrarian disposition can help cut off the excesses of the tails. The problem is we never really know beforehand the timing, time or magnitude of any new cycle.

Therein lies the problem.

Why Won't This Market Go Down?

The fundamental reason why this market may not go down (when for all intents and purposes it probably should) is because there are still plenty of investors still sitting on the sidelines just waiting for it to fall to get back in.

I hate the idea that the market level is in fact set by supply and demand rather than fundamentals. But you would argue that supply and demand are a part of fundamentals. Yes and no. Yes in the sense that the market is simply a market with prices set by supply and demand. But no in the sense that the market does not always reflect the fundamental economic reality of an asset.

When supply and demand are more a function of sentiment than economics, then perverse outcomes tend to happen.

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.

It's a set-up

Not an intentional set-up. Not a malelovent set-up. But a set-up all the same.

The set-up is this. The market is extended. But we already knew that. We have been conditioned to buy the dip (Bernanke put and everything). Everyone is happy. Stocks have gone up. There are no signs of disaster around. The economy is healing. However, there are signs of momentum sapping and sentiment changing. The coup de gras is a combination of respected commentators talking caution (Marks, Montier, Dalio, Gundlach), Fed tapering, meme that new Fed governor will be tested, geopolitical conflict & China cracking.

This is how the worm turns. And this is how it takes time for the market to digest the turn and then in turn justify the takedown. All of these things and more have been around a long time. Fear and risk are always there. But there are times when the market sits up and takes notice. I think now is one of those times. I am trying to lighten up going into mid-14, but it is hard to sell names that I think are good long term plays (even when I know they WILL take a 20%+ haircut in any takedown).

The Valuation Dilemma

The dilemma of a value oriented investor. When opportunities dry up (because markets have appreciated substantially and everything is a lot more expensive), it is still incredibly hard to sell…because (1) we are in the business of owning assets long term, (2) we don't know whether the market will continue to go up or go down, and (3) we know that timing the market is a pretty tough thing to get right consistently. So we stick with what we've got and are a prisoner to market movements.

Sitting Out A Rally

In our business you can't sit out a rally. Even if your philosophy and your process support such a move. The reason is because "the business of money management" will not allow to sit out a positively trending market and in the back of your mind you justify staying-in on the basis that "you can't time the market." The other thing is, each time you have attempted to go to cash, you have been steamrolled.

What this does is change you from an intrinsic value investor to a relative value investor.