Basically a Snake Don’t Have Parts

Coach Klein: That looks delicious. What part do you think I’m about to eat?

Mama: Well…basically…a snake don’t have parts. But, um, if I had to call it anything…I would say it’s his knee.

Coach Klein: Great, great. And what are we having for dessert?

<A bug zapper flashes and sizzles with new prey, just outside the window>

Mama: Squirrel.

The Waterboy (1998)

Narrator: And here, in a cave about 2 million years ago, the first artist was born.

[An artist puts the finishing touches on what looks like the (much more recent) cave paintings in Lascaux, France]

And, of course, with the birth of the artist, came the inevitable afterbirth…the critic.

[The critic proceeds to urinate on the cave art]

History of the World, Part I (1981)

It is the season of snark.

The end of any year is usually when strategists and investors begin publishing next year’s outlook pieces, typically with all sorts of predictions for financial markets. You know the drill: the S&P will be this or that on December 31, 2019, and the 10-year will be here or there.  I think there’s a 40% chance of this, and while I’m not predicting a recession next year, I think it may be in our future for 2020! It’s a racket, with pre-defined rules and few real consequences. If you guess right, you take a victory lap. If you guess wrong, you move on quickly and people forget about it.

It is also the time of year for the strategist’s inevitable afterbirth: the critic. Newspaper articles and other competing strategists comb through all the predictions, looking for those most worthy of ridicule. Some are sufficiently close to parody that the critic’s work is mostly done for him (think John McAfee’s unappetizing 2020 dinner plans), while in other cases, the predictor is respected enough that the criticism is usually leavened with hushed, respectful tones (e.g. Byron Wien). Prediction criticism is a racket, too, and it also follows a similarly predictable set of rules.

Why are they rackets? Because both ridiculously overconfident predictions and their unnecessarily on-the-nose criticisms are pure advertisements, bereft of any useful information. Advisers and institutional investors must tell their charges something as the year closes out, and the only two choices are (1) here’s what we think will happen, or (2) here’s why we think nobody knows what will happen. It’s all about whether you’re selling confidence or likability. Naturally, I happen to favor the latter, because it suits my temperament and because I think it’s usually a hell of a lot more accurate, but both of these are still shtick.

The most predictable shtick these days, however, is the environment for active management shtick – as in, “This is setting up to be a good environment for active management.”

This is a very stupid idea. But the typical criticisms for it are also very stupid.

Let’s unpack them both.

First, consider that any reason given in defense of the vaunted better environment for active management will inevitably take the form of one of these three ideas:

• There will be more volatility in markets and dispersion among stocks;
• Forces causing markets to rise and fall in unison (e.g. central banks) will relax; or
• Information disperses more slowly in this market, creating inefficiencies to exploit.

Please, for all of our sakes, if you’re going to play the variant of the above three rules that we call the “take a drink every time you read or hear ‘the fundamentals are starting to matter’ game” this holiday season, make sure you Uber or find a designated driver.

Fortunately, all this nonsense is easy pickins’ for the critic, who observes dryly that even if these above three states were to exist, alpha would remain a zero sum game, and that increased dispersion would simply cause the transmission mechanism between active share and active risk to rise. In other words, none of this changes whether active management will work better or worse on average, it just widens the gap between the winners and losers.

That’s obvious enough, I think? Except this idea, too, is right in all the ways that don’t matter and wrong in all the ways that do.  

Yes, yes, the market is zero sum and all that. But after she interviews a hundred fund managers, and only finds one or two that are actually overweight Apple or Microsoft, any realistic assessor of a public markets asset class will quickly come to the conclusion that the universes of active managers we most often refer to are not a reflection of the market capitalization weighted definition of that asset class. If you added up every position held by every US Large Cap mutual fund and separately managed account in the world, the portfolio you ended up with would look very different from the S&P 500.

Why? Because there are huge pools of unbenchmarked assets which would be included in a formal or academic definition of “active management”, but which exist outside of any practical definition of the universes that any asset allocator would encounter, like the actual funds, commingled funds, SMA pools and hedge funds that they can actually invest in.

These other pools are snake-and-a-squirrel portfolios, and they exist everywhere. These are not people or institutions sitting around matching what they own with a “US Mid Cap Growth” mandate. They are the holdings of wealthy individuals and restricted stock-compensated executives. They are the custom unbenchmarked (or poorly benchmarked) multi-asset income portfolios built by consultants and FAs. They are the one-off holdings of corporations, partnerships, banks and other institutions. They are the holdings of foreign investors who want to hold US stocks, but for whom that means buying the well-known megacap multinationals. And no matter how much we want Kathy Bates to tell us a comfortable story about how they’d fit into our style boxes and asset classes, they won’t. That’s why alpha is absolutely a zero-sum game in academic space, but is absolutely not a zero-sum game in any practical definition of our industry-related constructs of investable asset classes and products. What we invest in isn’t a set of strategies choosing to underweight or overweight the stocks in the S&P 500, but a set of strategies that invest in what’s left over after mama has served up a few hundred billion dollars worth of snake and a squirrel. 

The reality, then, is that there absolutely are good and bad environments for outperformance of the average fund in different asset classes, but they have nothing to do with pedantic zero-sum game arguments OR security-level dispersion. If you want heuristics for what an “active management environment” looks like, it’s this:

• Your actively managed portfolio will usually be underweight the defining traits of the index you have selected.
  • It will be less fully invested (i.e. it will hold more cash).
  • It will usually hold less of the market cap range in question (i.e. large cap will underweight large cap, small cap will underweight small cap).
  • It will usually hold less of the largest country weight.
  • It will usually hold less of the largest sector weight.
  • It will usually have a less pronounced bet on any factor (e.g. value) used to define your index.
• Your actively managed portfolio will usually be overweight volatility – not in the “long vol” sense we use to talk about benefiting from market volatility, but in the sense that your portfolios will tend to own more volatile stocks than your index. This is usually because most stock-pickers seek out stocks with more idiosyncratic risk, which (surprise) happens to be positively correlated with outright stock price volatility.

Don’t believe me? If you’re an FA, go through your fund lineup, approved list or fund database, and count off the funds who are overweight Apple and Microsoft. Count off the EM options you have available that are overweight China. Show me the small cap funds that beat the Russell 2000 when the Russell 2000 is roaring. They’re going to be rare.

Most of these traits and biases, of course, don’t have positive long-term expected returns. So all this does little to change the fact that active management is a brutally difficult game over long periods, especially after fees. But if you want to understand the reality underneath the abstractions and narratives being promoted in media and by your managers about active management vs. passive management, you’ve got to understand that the “environments for active management” are driven not by those stories you’re being told, and not by the skeptically dismissive arguments of the skeptic, but by these almost universal biases.