What can we do to inspire the renaissance in active equity portfolio management?
Over the course of our active equity renaissance series, we have dismissed the broken 1970s model of portfolio management and the cult of emotion. We also charted the rise and fall of modern portfolio theory (MPT), considered new frontiers of risk assessment, and discussed behavioral portfolio management concepts.
But how do we revive and sustain active equity?
After Clients, Elevate Buy-Side Analysts to the Starring Role
The active equity renaissance needs torchbearers — those who are committed to helping end clients achieve their goals. That means both buy-side research analysts and portfolio managers. After all, these individuals filter the universe of possible securities, purchasing or shorting assets, and building portfolios through their execution of investment strategies.
They must play the preeminent roles in security selection and portfolio management. For too long, their skills have been undermined by portfolio management guided not by an investment strategy, but by investment intermediaries — consultants, platform gatekeepers and investment committees. These intermediaries want managers to complete niche style boxes to fulfill an asset allocation strategy they believe is value added in achieving client goals. In other words, portfolio management is too much a product, and needs to return to being a profession.
Naysayers may contend that those whom we hope to elevate are the very people who should be demoted. But until someone proves that intermediaries actually help clients achieve their end goals, there is no reason to discount the expertise of fundamental analysts. Buy-side analysts are quite adept at security selection, according to research. Indeed, this same research offers insight into what choices must be made to deliver value to clients and to defy MPT’s slavish adherents.
Abandon Arbitrary Measures
Benchmarks were originally constructed to measure performance after the fact. Sadly, they have become targets for buy-side research analysts and portfolio managers to manage to before the fact.
To enforce this, investment intermediaries have developed measures — style boxes, style drift and tracking error — that are entirely arbitrary. Why? Because, again, they want managers to adhere to a niche strategy as part of an overarching asset allocation plan.
Yet Russ Wermers’s work shows that active managers who comply with such foolishness will be beaten by indexes. After all, active management should be about unleashing the capabilities of the human mind. Why rein these in with unnecessary requirements that destroy client value?
The goal is to beat an index by managing far away from it. Shadowing an index and spending money on researching or increasing the expense ratio is just a formula for expensive closet indexing. Instead, managers should be encouraged to create tracking error.
If a quality value manager, for example, buys a portfolio of undervalued securities, eventually the prices of those securities may appreciate. This, in turn, may lead to style drift, from value toward growth, creating tracking error and style-box violation — all because the manager did the job well!
A look at the academic literature that created these measures shows just how capricious they are. For example, style boxes, like those championed by Morningstar, are the application of identified equity market anomalies, the small-cap and value effects.