The miracle that will save active investing

By Markets Covestor

“Move to passive likely to build more steam” is a front page story in the September 15 issue of Pensions & Investments, the newspaper for pension consultants and fiduciaries. The sub-heading for the article reads: “But any paradigm shift is seen as a long way off.”

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In other words, active investment management is dying a slow death, and for good reasons. I’d like to explore the shortcomings of active investment management and offer a miracle that could save it. It’s not too late.

 

 

Lagging Returns

Numerous studies by S&P, Vanguard, Morningstar and others prove that active investment management fails to outperform passive, especially after fees and expenses.

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Furthermore it is now well understood that, in the hierarchy of performance sources, asset allocation is king, explaining up to 100% of actual performance results. The other aspects of performance, namely timing and manager selection, tend to subtract value.

Bottom line, studies show that investment portfolios perform better when all underlying assets are passive. This result is attributed to efficient markets. It’s very difficult to beat the consensus, especially a market that is dominated by professionals.

 

Fine Dining

In his popular book, What Investors Really Want, Professor Meir Statman, a behavioral scientist, tells us that investors like and want the entertainment and bragging rights that come with active management.

He compares the choice between active and passive to the choice between fine dining in restaurants and eating health food at home. Fine dining is more fun, but not so good for our health.

Investors want to play the investment game, and they want to win. They believe their investment advisor can make that happen.

Some investors know that the odds of winning are less than 50/50 – the odds are against them. But they believe that, together with their advisor, they can outwit everyone else.

Just as fancy restaurants don’t discourage patrons, advisors don’t discourage active management, even though it would take a miracle to actually deliver skillful management.

 

Due Diligence

Hunter S. Thompson, author, says “Anything worth doing is worth doing right.” The miracle that could save active investment management is contemporary due diligence that actually identifies skill, even though it is much more work than the antiquated approaches advisors have used for the past 40 years.

As I’ve written elsewhere, if investors ask the right questions before hiring a financial adviser they have a far better chance of success:

Hiring an active manager is like hiring a professional gambler. In both cases, you want to understand the following four Ps before you entrust your money: People: Who are the individuals? Are they smart? Clever? Worthy of my trust? Process: How do they gain an edge? What’s their story? What game (s) do they play? Philosophy: How do they view the game? What strategies do they employ? Performance: What tournaments have they won?

 

Indexes and peer groups do not work – never have and never will. Consequently, investors hire losers, and are constantly disappointed. “Always change a losing game” advises Dr. David Posen, speaker and author.

Active managers should pray for this miracle but they fear what it might show. Advisors won’t accept the miracle until clients become frustrated enough to fire them. Change comes hard, but clients deserve better.

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Disclaimer: All investments involve risk and various investment strategies will not always be profitable. Neither the information nor any opinions expressed constitutes investment advice and is not intended as an endorsement of any specific portfolio manager. Past performance does not guarantee future results.