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.

China Is Melting Down

China is melting down but no one knows it or sees it.

The signs are all there. Falling growth (everywhere). Myriad government attempts to pump liquidity and capital into the system. The market still in make believe mode.

Panic has not set in. Commodities have been the canary in the coal mine, but no one seems too concerned. My bet is the property development sector will provide the trigger. Weakness in the Yen has set about the next leg of the global currency wars. Stresses and strains are showing everywhere (Europe, Japan, Latam, Australia).

We are in the calm before the storm. Batten down the hatches.

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.

Investing - A contact sport?

Investing is not a contact sport.

Investing should be a spectator sport.

If you spend your time watching the proceedings, then you will invariably be drawn into the fray and that is where mistakes are made.

Jumping the Shark in Financial Advisordom

I am inundated with financial advisor magazines. I could have sworn there were only one or two a couple of years ago. Now there seem to 10 to 20 different magazines all trying to do the same thing - sell services to advisors.

It reminds me of the technology bubble and all those technology magazines I use to get back during that blow-out.

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. 

The Conceit of Value Investing

Value investors rightly argue that if you focus on acquiring undervalued assets, ie. assets trading below intrinic value (whatever that is...certainly no objective measure...a post for another day), then the market will eventually come around to recognizing the firm is worth more than what it is currently and start bidding up the price.

The irony or conceit of value investing is that it is generally in a bullish (positive growth) economic environment that either the company's fortunes turnaround or the market has pushed the value of growth and momentum names so high that it is now looking for valuation arbs and comes down to the value end of the market to find those opportunities. A positive economic environment gives the market the confidence to take a punt on a distressed asset and time is the healer of all things (which is why value performs best at the end of a cycle - it is playing catch-up).

Value investors will also argue that value investing works in down markets because you have purchased assets at depressed prices and that provides a cushion (margin of safety) relative to the high priced (multiple) growth and momentum names that have led the market. That has not generally been my experience. In a large market pullback all names seem to fall together.

Value names tend to outperform at the beginning (inflexion point) in a market cycle and toward the middle-end of a market cycle. Growth and momentum names dominate (or lead) the market through the middle of a cycle.