Monday, July 6, 2009

No Surprise and a Wonderful Opportunity

Rob Heubscher is the publisher of the Advisors Perspectives e-letter, and as the name implies it is widely read in the financial planning community. What isn’t as obvious is the quality of the contributors to the letter which is rapidly becoming one of the most influential in the advisory business. All of which is why I was thrilled when Rob offered to reprint Chapter 7 of my book, Buy and Hold is Dead (AGAIN) as a lead article in Advisor Perspectives. I just checked the site and the article, called Compelling Evidence that Active Management Really Works remains the number one most read article by advisors over the past 14 days. Thank you, Rob, for such a wonderful opportunity to introduce financial advisors to my book.

It is no surprise that financial advisors are fascinated with the topic of the chapter, which refers to one of the longest ongoing debates in the planning profession. Simply put, can an active money manager, constrained to one management style, outperform a passive benchmark representing that one style? The chapter reviews the work of Yale Professor’s Cremers and Petajisto and their seminal work on Active Share, which is a method of measuring both the difference in portfolio performance (tracking error) and portfolio holdings (active share) in determining a manager’s performance. Their surprising conclusion is that active management, as measured by active share, actually adds persistently and significantly to fund performance. In the planning industry, where active managers are typically bought and held strategically to invest in only one asset class, this news is dramatic and important. Theoretically it proves that asset classes should not be indexed but should instead be invested by actively managed mutual funds, separate accounts, etc.

Ironically, I’ve always felt that this was the least relevant chapter in the entire book. My thesis is that there is a difference between portfolio managers who can invest in the entire universe of asset classes, and money managers who are constrained to only invest in one asset class, be it large-cap value, small-cap growth, emerging international, etc. The important question is not whether a style constrained money manager can beat a single performance benchmark, but instead whether a non-style constrained portfolio manager, with almost unlimited access to every asset class, can identify value in a world of mispriced asset classes. If so, then active management is necessary in order to earn excess returns. I hope the distinction between the roles of money managers and portfolio managers is not lost on the readers. I also hope that portfolio managers will allow themselves the freedom to move money from overvalued to undervalued asset classes, something that strategic asset allocators insist cannot be done successfully.