Review: Return of the Active Manager

Active portfolio management is dead, killed by the superior performance of cheaper stock index funds.

Or is it?

In Return if the Active Manager, C. Thomas Howard and Jason Apollo Voss make the case that active management may actually be on the verge of a major comeback.

As recently as 2009, active mutual funds enjoyed a market share of over 75%, with passive index funds making up less than 25%. In 2018, active and passive funds reached parity, with each taking about 50%. It’s safe to assume that, once the numbers are tallied, passive funds will overtake active funds in 2019. Howard and Voss eventually expect the split the stabilize at roughly 70% passive index funds and 30% actively managed funds.

It’s not hard to understand why. As Howard and Voss explain it, the fund industry is structured to force active managers into being closet indexers, which is a battle they can’t win. They can’t beat the index if, in the authors’ words, “active managers are being asked, not just to beat the index, but to do so with the same securities, the same industry weightings, no tracking error, no style drift, the same volatility, with lower expenses,” etc.

The authors make a compelling case that Morningstar and its style boxes are to blame. While Morningstar intended for their style boxes to describe and evaluate funds after the fact, instead they became a straightjacket of investment constraints before the fact.

Because of the need to fit within a Morningstar style box, managers get forced into a game they can never win. The only way to beat an index is to do something fundamentally different, which means “style drift” or “tracking error.”  

As Howard and Voss explain it, the unintentional outcome was “the bland sameness in investment management strategies, leading to consistent underperformance of closet indexers…”

If the situation looks bleak for active management, the good news is that its destruction brings opportunities. As others, such as Mike Burry and Bill Ackman, have noted, indexing only works when there are active managers whose informed trading forces prices into a state of efficiency (or something close to it). If there are no more active managers, then passive investing stops working effectively.

As Howard and Voss explain, “As stocks are increasingly held by index funds, which simply respond to investor flows rather than fundamental  company information, stocks become increasingly mispriced… The implication is that as investors flee closet indexers and move their money into low-cost index funds, stock picking opportunities improve.” Hence the return of the active manager.

This brings Howard and Voss to the core of their argument. They see the future of active management being one in which Morningstar style boxes are irrelevant, as are all performance metrics that depend on the CAPM or the Efficient Market Hypothesis. Instead, active managers will focus on exploiting the stock picking opportunities created by excessive indexing.

This behavioral finance approach takes it as given that market prices are driven mainly by emotional crowds, and that investors are not rational. By understanding this – and by managing your own emotions – you can take advantage of market anomalies.

In evaluating active managers, Howard and Voss offer a few suggestions. First, look for managers that are pursuing a “narrowly defined strategy with consistently and conviction.” You’re looking for a specialist, not a generalist. Secondly, look for smaller managers with less than $1 billion in any single strategy. And finally, look for low correlations. Howard and Voss suggest looking for funds with R-squared values (a common measure of the degree to which a fund tracks an index) of below 0.80.

As active managers specializing in behavioral finance, Howard and Voss clearly have an interest in investors following their advice here. But their analysis is solid, and investors would be wise to take it seriously.

My compliments to the authors.  

Review: Skin in the Game

It’s morally wrong to enjoy the benefits of something while leaving others to accept all the risks.

This is the central theme of Nassim Nicholas Taleb’s latest work, Skin in the Game: Hidden Asymmetries in Daily Life, a book that should be required reading for anyone in public office or in any position of authority or influence. And by “position of authority or influence,” I’m not speaking only of politicians or journalists. I would include everyone from the town doctor to the b-list celebrity with a large Twitter following.

The concept of skin in the game can be best understood by what Taleb calls the “Silver Rule,” or the flip side of the Golden Rule to do unto others as you would have them do unto you: Don’t do onto others what you wouldn’t want them to do to you. Don’t expose others to harm unless you are also directly or indirectly exposed.

As an example of what that looks like in the real world, consider ObamaCare. Our leaders passed legislation that caused a massive spike in the cost of health insurance — doing real harm to tens of millions of Americans — while accepting none of the risk. Congressmen don’t buy their health insurance on an ObamaCare exchange and are given — at taxpayer expense — vastly superior health plans. [Note: this is my observation; I don’t know Taleb’s views on ObamaCare.]

Or, as Taleb has pointed out in the past, consider the Iraq War and the various Western interventionisms in the Arab world. Our leaders might have been less interested in regime change if, like the kings of ancient times, they had to lead the army from the front.

Skin is less structured and less technical than Taleb’s previous books and will be far easier to digest for a non-financial reader. It feels less like a book and more like a long, animated chat with Mr. Taleb in a cafe over several strong cups of coffee.

I  thoroughly enjoyed Skin in the Game and that I strongly recommend it. But if you are new to Taleb’s work, you shouldn’t start with this book. It will make more sense and you’ll get more out of it if you’re already familiar with Taleb’s core ideas: the role of randomness in life, naive empiricism, black swans (low-probability but high-impact events), fragility vs. antifragility, etc.)

I recommend you start by reading his first book, Fooled by Randomness, particularly if you have a background in finance or trading. I first read it in 2002, and there are precious few books that have had more of an influence on me.

But if you are familiar with Taleb and generally like his work, you’ll find Skin in the Game to be a worthwhile addition to your library. It has that peculiar cocktail of  logical reasoning, historical perspective, statistical rigor and good old-fashioned street smarts that Taleb is known to mix.

Before I sign off, I’d like to end with a quote of Taleb’s that made me smile… because it is something that I myself have done. If you’re going to start a business, you should put your name on the door. As Taleb puts it, “products or companies that bear the owner’s name convey very valuable messages. They are shouting they have something to lose. Eponymy indicates both a commitment to the company and a confidence in the product.”

I couldn’t agree more.

Kudos to Mr. Taleb on another solid work, and I look forward to the next one.

See also:

The Bed of Procrustes


You Can Be Right And Still Be A Moron

I stumbled across a really good quote from Dr. Daniel Crosby’s The Laws of Wealth that I may have printed and laminated into a wall-sized poster:

… on Wall Street, doing what is “right” can lead to a negative short-term result and doing what is “wrong” can be spectacularly profitable in the short run. Consider the story related by Paul DePodesta, a baseball executive made famous in the book Moneyball. He says on his blog, It Might be Dangerous:

Many years ago I was playing blackjack in Las Vegas on a Saturday night in a packed casino. I was sitting at third base, and the player who was at first base was playing horribly. He was definitely taking advantage of the free drinks, and it seemed as though every twenty minutes he was dipping into his pocket for more cash.

On one particular hand the player was dealt 17 with his first two cards. The dealer was set to deal the next set of cards and passed right over the player until he stopped her, saying: “Dealer, I want a hit!” She paused, almost feeling sorry for him, and said, “Sir, are you sure?” He said yes, and the dealer dealt the card. Sure enough, it was a four.

The place went crazy, high fives all around, everybody hootin’ and hollerin’, and you know what the dealer said? The dealer looked at the player, and with total sincerity, said: “Nice hit.”

I thought, “Nice hit? Maybe it was a nice hit for the casino, but it was a terrible hit for the player! The decision isn’t justified just because it worked.”

My shorthand for the concept illustrated by DePodestra’s story is, “you can be right and still be a moron.” Perhaps you know a friend who gambled big on a single stock and made a great return. Results notwithstanding, your friend is a moron. Maybe you jumped out of the market right before a precipitous drop because of nothing more than a guy feeling. Lucky you, but you’re still a moron.

Exceptional investing over a lifetime cannot be predicated on luck. It must be grounded in a systematic approach that is applied in good times and in bad and is never abandoned just because what is popular in the moment may not conform to longer-term best practices.

Charles here. You could also sum this up with “don’t confuse brains with a bull market.”

We’ve all been there. You made a terrible trade based on faulty logic (or no logic at all). You misassigned probabilities or ignored the risk you were taking. You shot from the hip. And maybe it worked out. (I’m not picking on you, by the way. I’ve done it too…)

Just don’t learn the wrong lesson from it. A good outcome doesn’t mean it was a good decision. And plenty of good decisions have really lousy outcomes. Randomness is a big part of it. This is the nature of a world in which we have to make decisions with imperfect information.




Book Review: High Returns from Low Risk

We all know that higher returns come at the cost of higher risk. This is one of the basic fundamentals of investing.

But what if it isn’t true?

In High Returns from Low Risk: A Remarkable Stock Market Paradox, Pim van Vliet and Jan de Koning challenge this assumption and find that, in fact, high-risk (i.e. high-volatility) stocks actually underperform their more conservative, staid peers. Van Vliet and de Koning found that, over the past 86 years, a portfolio of the least volatile stocks (lowest decile) outperformed a portfolio of the most volatile stocks (highest decile) with annualized returns of 10.2% and 6.4%, respectively.

Van Vliet and de Koning are anomaly hunters, and I would include them among the growing evidence-based “smart beta” movement that seek to build a better mousetrap than traditional cap-weighting indexing.

It would be easy enough to stop here and suggest that Van Vliet and de Koning’s advice was simply to buy and hold low-volatility stocks. (You could argue that this is essentially what Warren Buffett’s strategy at Berkshire Hathaway has been for the past several decades, buying a leveraged low-vol portfolio with insurance float.) But Van Vliet and de Koning take the analysis a step further, incorporating value and momentum strategies into the mix.

Van Vliet and de Koning suggest using a combination of dividend yield and buyback yield (collectively called “shareholder yield” in certain cases, though Van Vliet and de Koning do not use that phrase in the book) to screen for value. But as a way of avoiding value traps — stocks that are cheap for a reason — they also suggest using a momentum filter. In plain English, they look to avoid cheap stocks that just keep getting cheaper.

As for why these anomalies persist, Van Vliet and de Koning have their theories. The need by professionals to hug their benchmarks, excessive short-termism by both professional and retail investors, and low-volatility stocks’ overall lack of sex appeal are all factors.

The question in my mind is whether the anomalies are sustainable, as profit opportunities tend to get arbitraged away. Van Vliet and de Koning ask the same question towards the end of the book and reach the conclusion that, so long as asset managers continue to chase performance relative to a benchmark, low-vol investing should continue to outperform.

Book Review: Get Rich With Options

I recently had the opportunity to pick up a copy of Lee Lowell’s 2009 book Get Rich With Options: Four Winning Strategies Straight from the Exchange Floor.

Lee wrote an excellent primer on options trading, but the publisher probably should have put a little more thought into the title. Get Rich With Options has very little to do with getting rich with options. Instead, it is a level-headed explanation of various low-risk options trading strategies that generate small, consistent profits over time.

(Though to be fair, “Generate Small, Consistent Over Time With Options” doesn’t look quite as good in print.)

For readers who are accustomed to thinking of options trading as a high-risk/high-return endeavor, Lee’s book will be a real eye-opener.

Most of what Lee does revolves around selling options rather than buying them. Yet interestingly, his first strategy is buying deep-in-the-money options as a substitute for stocks.

This is the polar opposite of how most options speculators operate. Most tend to buy cheap out-of-the-money options with something of a lottery-ticket mentality. The returns to buying out-of-the-money options are potentially much higher. Of course, there is also the high likelihood that the option expires worthless and you lose your entire investment.

When an option is deep in the money, it moves in virtual lockstep with the underlying stock. (For the experienced options traders out there, Lee generally recommends buying the deepest in-the-money options available with a delta of at least 90 percent.) But, you initial investment is significantly lower. So, you get the same potential upside on a much smaller investment with lower downside. For a short-term stock trade, that makes all the sense in the world.

Lee’s next strategy is my personal favorite: selling naked put options. Though I rarely sell puts personally, I regularly use outside managers that do. It’s a fantastic strategy for generating consistent income and functions, in principle, like an insurance company. Like an insurance company, the seller collects consistent premiums, though once in a while, disaster (i.e. a market decline) will strike, and you have to pay out a “claim.” (Note: The insurance analogy is mine, not Lee’s. I don’t want to put words in his mouth.)

Lee sees two important elements to put selling. First, selling the options generates immediate income. But secondly, put selling can allow you to buy a stock you want at the price you want. It’s a coin toss in which you win both ways. Heads, the stock rises and you keep the options premium. Tails, the stock price falls, you still keep the option premium, but you buy the stock at a price you consider reasonable. There is the risk that the stock could fall much lower than your stock price, but you would have carried that same risk had you simply bought the shares outright. There is really nothing not to like here.

Lee’s third strategy — his favorite — is actually a collection of spread strategies that involve using multiple options contracts to limit the cost of trading. This is something that many new traders may find intimidating, but Lee does a good job of breaking down the trades into digestible pieces that even a beginner can understand.

And finally, Lee’s fourth strategy is covered call writing. In Lee’s first strategy, he recommends buying options that are deep in the money. But covered calls are a different animal. When you sell a call option against a stock you own, you’ll looking to earn a little extra income from the stock above and beyond its dividend and regular capital gains. But you’re not wanting the option to get exercised, as that means selling the stock. Ideally, a covered call option expires worthless and you simply pocket the premium.

I would add that, in today’s low volatility environment, Lee’s options strategies are less profitable than they would be in a more “normal” volatility regime. That’s ok. This is the time to read up on the strategies so as to be prepared when the opportunities reappear.

If you are new to options trading — or even if you are an experienced hand — I recommend giving Get Rich With Options a read.