Two institutional managers I do know – one at a Fortune 500 defined profit pension fund, the opposite at a municipal pension fund and later at a foundation – consider in focusing entirely on lively management. For them, 100% lively allocation isn’t only okay, but desirable. Of course, anyone accustomed to the statistical odds of choosing overperforming lively managers knows how incredible and fallacious this approach is.
That’s why I’m asking true believers in lively management to share their academic and skilled insights on why lively management is the higher way. I find it baffling that so many in our industry, when expressing an opinion on the entire thing, cite so few strong and informed sources to support their view.
For my part, I even have six observations listed below that help me approach the lively vs. passive query. Of course, they’re removed from exhaustive.
Finally, manager selection isn’t a straightforward process. Essentially, the idea is that lively managers can outperform and that these managers will be identified early. Certainly the manager selection literature has a vocabulary and an inexpensive framework for excited about the challenges, however the holy grail of the dilemma – knowing when to be lively and when to be passive – stays elusive.
In fact, lively evaluation depends upon reasonable forecasts of ex-ante lively alpha risk, each by way of optimizing alpha and strategic asset allocation.
However, I have never replaced all the things lively with passive ones. But I, together with others in my company and within the industry, are examining fastidiously how I can overcome these challenges. Make no mistake, our industry will proceed to maneuver towards passive. But there are opportunities for lively things. When it involves manager selection and the active-passive debate typically, I like to recommend keeping the next in mind:
1. There are not any bad backtests or bad narratives.
This is especially true for workers in sales or business development. But while it is easy to sound good and construct a compelling story, it’s much harder to present a quantitative approach that analyzes attribution on reflection and understands prematurely how that process can lead to alpha. It’s a giant task and no pitch I’ve heard has ever done it well.
Investors shouldn’t should figure it out on their very own. You can expect lively managers to define and measure their ex-ante alpha, especially in the event that they simply extrapolate it from the past. But investors need to judge these ex-ante expectations or have an informed forecast about where that alpha will come from.
2. Indexing outside of market cap may help discover market inefficiencies.
This extends lively management to index selection and management. Even small differences could make a giant difference in how a sub-asset class performs in an index. For example, while the S&P 600 and Russell 2000 are market weighted and intended to reflect the small-cap universe, they’ve very different inclusion and exclusion criteria that can lead to significant differences. Furthermore, index variations may try and capture the well-known aspects documented in academic and practical research—the so-called “factor zoo”—that too many have dismissed out of hand.
3. Are our prejudices our friends?
If we truly query the efficiency of a market, we may find a way to pre-assess a specific area of the investment universe and invest accordingly. But such beliefs must transcend the overall and obvious: we want something more concrete and specific than “Markets cannot be efficient because people are not rational.”
4. When unsure, remain passive.
We are all imperfect, however the strength of our beliefs matters. If we’re only at a 7 and even an 8 on an ascending trust scale of 1 to 10, we should always proceed passively. Given the chances, “warm” isn’t enough to take motion.
5. Cost and manager ownership could make for good screens
Does an lively manager charge excessive fees? What is the ownership structure of the fund? If the answers don’t reflect well on the manager or fund in query, it is likely to be idea to avoid them.
6. Consider a core-to-satellite approach
This gives us an error budget. For example, we may limit our lively exposure to not more than 20% to 30% of our policy allocation. In this manner, our passive exposure will all the time give us reasonable top quartile return expectations over the long run. The top quartile is impressive.
On a bigger level, it might make sense to reframe the complete active-passive debate. The query: lively or passive? – will not be the best query. Will I gain access to the market that I cannot access through a benchmark? Is there real inefficiency on this market? Maybe these are the questions we ought to be asking ourselves.
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