Ready for a sea change in active management? According to “The Fundamental Law in Mismanagement,” a recent paper by Richard Michaud of New Frontier Advisors in Boston, the most basic tenet of active equity management is seriously flawed.

Grinold and Kahn’s Fundamental Law of Active Management elegantly states that the best way to add value in an active portfolio is to make as many small bets as possible. The theory is based on the notion that the stock market too efficient to allow for a small group of hand-picked stocks to consistently beat the market on a risk-adjusted basis; as a result, the best way to add value is to strategically overweight or underweight a much larger number of securities.

In Mr. Michaud’s view, increasing the population of securities is a big mistake, simply because an analyst constrained by time and resources cannot possibly follow more companies in a thorough manner.

This may be true, but in my view, his theoretical framework does not take into consideration the increasing role of technology in vetting new ideas. Quantitative money management, which uses computer models to select securities, should actually do better as they further diversify, not worse. Likewise, a host of fundamentally-driven firms that have massive research budgets are well-suited to increase their potential universe of activity.

If Mr. Michaud is right, there should be some evidence to support his findings. Mutual funds with concentrated portfolios should have outperformed more diversified offerings on a risk-adjusted basis, for example. And reasonably priced active management should have taken indexation head-on and won the battle. Neither of these has come to fruition.

Grinold and Kahn’s law have a few flaws, of course. Transaction costs are not considered, and some of the variables used are difficult to measure. But I think they got much more right than they did wrong. I predict that their work will continue to be used by a host of large investment firms going forward.

The Monthly Index Report for March 2006

Index

Feb-06

QTD

YTD

Description
S&P 500 Index*

0.05%

2.59%

2.59%

Large-cap stocks
DJIA*

1.18%

2.57%

2.57%

Large-cap stocks
Nasdaq Comp.*

-1.06%

3.45%

3.45%

Large-cap tech stocks
Russell 1000 Growth

-0.16%

1.59%

1.59%

Large-cap growth stocks
Russell 1000 Value

0.61%

4.52%

4.52%

Large-cap value stocks
Russell 2000 Growth

-0.53%

9.06%

9.06%

Small-cap growth stocks
Russell 2000 Value

-0.01%

8.26%

8.26%

Small-cap value stocks
EAFE

-0.21%

5.93%

5.93%

Europe, Australasia & Far East Index
Lehman Aggregate

0.33%

0.34%

0.34%

U.S. Government Bonds
Lehman High Yield

0.67%

2.27%

2.27%

High Yield Corporate Bonds
Calyon Financial Barclay Index**

0.13%

1.05%

1.05%

Managed Futures
3-month Treasury Bill

0.61%

All returns are estimates as of February 28, 2006. *Return numbers do not include dividends. ** Returns are estimates as of February 27, 2006.

Ben Warwick is CIO of Memphis-based Sovereign Wealth Management. He can be reached at ben@searchingforalpha.com.