What is it, really?

Hygiene Inspector: If I may begin at the beginning? First, there is the cherry fondue. Now this…is extremely nasty. But we can’t prosecute you for that.
Mister Milton, Owner and Proprietor of Whizzo Chocolate Company: Agreed.
Inspector: Next, we have Number 4: Crunchy Frog. Am I right in thinking there’s a real frog in ‘ere?
Milton: Yes, a little one.
Inspector: Is it cooked?
Milton (confused): …No?
Milton: We use only the finest baby frogs, dew-picked and flown from Iraq, cleansed in the finest quality spring water, lightly killed, and sealed in a succulent Swiss, quintuple smooth, full cream, treble milk chocolate envelope, and lovingly frosted with glucose.
Inspector: That’s as may be, but it’s still a frog!
Milton: What else would it be?
Inspector: Well don’t you even take the bones out?
Milton: If we took the bones out, it wouldn’t be crunchy, would it?
Inspector: Constable Parrot ‘et one of those!
Milton: It says “Crunchy Frog” quite clearly.
Inspector: Well, never mind that. We have to protect the public. People aren’t going to think there’s a real frog in chocolate. The superintendent thought it was an almond whirl! They’re bound to think it’s some kind of mock frog.
Milton (offended): Mock frog? We use no artificial preservatives or additives of any kind!
Inspector: Nevertheless, I advise you in the future to replace the words “Crunchy Frog” with the legend “Crunchy Raw Unboned Real Dead Frog” if you want to avoid prosecution.
Milton: What about our sales?
— Monty Python Live at the Hollywood Bowl, “Crunchy Frog” sketch (1982)

It has been pointed out to us that we write rather a lot about philosophy and psychology for a website/blog/newsletter about investing.

Is this surprising? This should not be surprising. All of us are in the business of prediction. Thankfully, not all of it is explicit prediction, like saying that we think that the price of Walmart stock will be $120 in three years, or that Tesla will be bankrupt in four years. Most of it is implicit prediction, like the way that investing money in something risky implies all sorts of things about the returns we expect from it. Predictions all the same. And any activity like this relies on developing confidence in some basis for creating (or assuming) those predictions.

Philosophy, and specifically epistemology, asks how we can know the things we need to make those predictions. Are conditions, traits, features of the thing we’re predicting observable? Are their responses observable? With what confidence may we infer traits from similar things we have observed? Further, may we reason how those traits might interact with other things to allow prediction? Psychology asks how accurate those human observations might be. It asks what evolutionary processes may have colored or influenced what we know, and what we think we know. It posits heuristics that might substitute for empirically-driven reasoning, whether helpfully or harmfully. Furthermore, in a field like investing that is responsible for making predictions about human behavior itself, psychology is recursively relevant, in that it studies both the tool of the observer and the observed.

Psychology and philosophy are critical tools for the investor. But in addition to being particularly ripe fields for bullshit, they also suffer from one of the same tendencies that plagues investors: people get so hung up on terminology and conventions that they start saying and doing dumb things. As always, the shrewd investor avoids that behavior himself and for his clients and capitalizes on it in others.

The Tyranny of Terminology

Of course, that gasbag introduction was just a way to tell you that I got into a little debate about Jordan Peterson.

If you don’t know much about him, Peterson is a professor of psychology at the University of Toronto, a cultural commentator and a bit of a rabble-rouser. As a psychologist and academic, he is heavily cited and as far as I can tell (which is not very far, but judging by citations alone), well-thought-of in his field. As a cultural commentator, he is thoughtful and incisive as a proponent of self-control, advocate of free speech, and opponent of what he characterizes as Neo-Marxism and Postmodernism, especially in the American university. As a scientific historian of philosophy? Well, this is where things get a little more controversial.

You see, the piece I was discussing with a very thoughtful senior staffer at a large U.S. university endowment (don’t tell my salespeople I’m getting into philosophical debates with clients and prospects, please and thank you) made the argument that Peterson was the wrong choice for a public conservative intellectual. The argument, if I may summarize, finds fault with him because (1) he attracts an audience of mostly young white males, (2) the traits he ascribes to Postmodernism are cherry-picked and not entirely correctly as derived from the history of the movement, and (3) he uses the terms “Neo-Marxist” and “Postmodern” seemingly interchangeably despite the different heritage and intellectual evolution of the terms and associated philosophical movements. The piece is a rousing little number, and almost enough to make you want to sit through that whole documentary on Jacques Derrida. (No, not really. Good Lord.)

Guess what? All the claims are pretty much true. Guess what else? None of them matter. I’ll get back to why, but first, I want to talk about another very current example.

You may have seen that Steven Pinker, cognitive pyschologist scientist at Harvard, published a new book called Enlightenment Now. Now, the reality is that the book doesn’t really undertake much discussion of the specifics of schools of enlightenment thought per se, but rather tells the story of human progress over the last 200 years. It makes the argument that these improvements are vastly underestimated and underappreciated. It also connects those achievements to specific influences of science and reason, sometimes very compellingly and sometimes somewhat less so. It is an encouraging and energizing read, even where its contentions are less well supported. I, for one, think there’s rather a lot in the 20th century alone that a purely scientific approach to curing society’s ills has to answer for. But much of the criticism has little to say about that, instead grousing that the science and reason the book discusses aren’t really about THE Enlightenment, but about principles of the Scottish Enlightenment specifically, and even then only about a subset of principles that Pinker particularly likes. After all, Marx was just a natural extension of the French Enlightenment!

Are you detecting a pattern here?

There are a lot of different kinds of talk about Enlightenment Principles right now. Ben and I write about them a lot. Ben wrote about them back in 2016 in Magical Thinking, and later in Virtue Signaling, or…why Clinton is in Trouble. I wrote about them in short last year in Gandalf, GZA and Granovetter. The remarkable new web publication Quillette provides a platform for writers who are thinking about them. The Heterodox Academy is building a strong core of support for them in universities. Pinker is talking about them. Chomsky has been speaking about them for decades. Hitchens, too, before he passed. In his own way, Taleb is talking about them (although he’d dislike the company I’ve chosen for him thus far). Peterson won’t shut up about them. Many of these same people — and some others — are simultaneously issuing criticisms of what is purported to be a diametrically opposed philosophy. In the early 2000s, the scandalous moniker applied was “Cultural Marxism.” Today this opposition is usually generalized into references to “Neo-Marxism” and “Postmodernism.”

But here’s the biggest shocker. Get out the fainting couch: they’re not all saying the exact same thing.

These are thinkers focused on many different areas, and so there are all sorts of topics where they disagree, sometimes vehemently. All would say that they believe in logic, truth and rationality, I think, but would define those things very differently. Most of the folks in the list above, for example, believe in a rationalism that inherently excludes faith. They are among the most prominent atheists of our time. They typically adhere to empiricism and the scientific method as the primary — even sole — method for transforming observations about the world into predictions. For two of them, Taleb and Peterson, rational thought means also incorporating evolved heuristics, intuition, instinct and long-surviving human traditions. This is not fringe stuff, but the logical conclusion of any serious consideration of Hayek and spontaneous order. It also means particular sensitivity to scientific techniques that end up equating absence of evidence with evidence of absence. All this means when you see many of the above names together, it’s…not always friendly. Like, stuff you can’t really walk back. Even among the two primary authors of this blog there are differences in how we see these things. I haven’t talked to Ben about it, but if I gave him the list of the above, I’d guess he’d hitch his wagon to Hitchens. Me? I’m probably closer to Taleb or Peterson.

What I doubt you’d find much of from this group is navel-gazing about terminology on the issue of postmodernism. While Voxsplainers and science historians quibble (very justifiably in the latter case) about whether there is a “discrete, well-defined thing called the Enlightenment” or whether it is fair to use “Postmodernism” in reference to a movement to esteem individual experience as peer or superior to free inquiry and free expression, the rest of us know exactly what people are talking about when they talk about this issue.

Don’t believe me? Fine. Go Full Cosmo and ask people you know these four questions:

Should governments and other important institutions abridge or allow (e.g., through Heckler’s Veto) the abridgement of some speech to protect people from speech which we think may be harmful to society, especially to historically oppressed groups?

Should we restrict the examination or evaluation of certain topics, especially when allowing them would prop up harmful social structures (especially power and class structures)?

Should we be skeptical that certain features and traits of the material, cosmological and biological world can ever be objectively true or important, considering the biased social lenses through which they are observed?

When making predictions about the world, should we consider personal experience and truths as equal or superior to whatever is uncovered through rational evaluation of the empirical merit or survival of a fact, idea or principle?

If you don’t think there’s a real thing happening in academia, in the public sphere, in politics and in creative media between those with three or four responses on opposite ends of the spectrum, I don’t know what to tell you. But I do know that this intuitive, arbitrary, subjective scale that I made up right just now is going to do a lot better job telling you about what people are referring to as a conflict between “Enlightenment” and “Postmodernism” than any etymologically thorough review of the terms themselves. How do I know this? Because it asks the question we should all ask any time that we see prediction or analysis oriented around terminology, categories, benchmarks, titles and jargon:

“Yes, but what is it, really?”

What is it, really?

There isn’t a question I can think of that an investor ought to ask more often, especially when it comes to any interaction they have with a representative of a financial services company trying to sell them something. And as Ben has written, all financial innovation is either finding a new way to sell something (securitization) or a new way to borrow money on things (leverage). The name of the thing being sold isn’t always a very good representation of what the thing is, sometimes for innocent reasons, and sometimes because crunchy, raw, unboned, real, dead frog doesn’t sound very appetizing.

Now, obviously the origin of most investment terminology, conventions, and even jargon IS innocent. Usually their purpose is to reduce complicated or large sets of data or principles to like dimensions. This is pretty helpful for communication and analysis. If we were constantly redefining the generally accepted conventions for a concept like “U.S. Large Cap Stocks”, for example, we would find it difficult to do a great many things with much efficiency. Economic constructs like sectors and common investment styles also have their appeal for this reason.

The problems, however, come in one of two flavors: first, as terminology becomes convention within an industry, we get further and further removed from a fundamental understanding of what the thing actually is. When we talk about U.S. Large Cap Stocks as a sort of monolithic entity unto itself, we forget that there is a lot going on underneath the hood. Sectors are changing. Companies, even entire industries are born and dying. New IPOs, companies slipping out into small cap land, companies bought out by private equity. We forget the nature of our fractional ownership, and the limited mechanical reasons why a stock’s price might rise and fall. The nature of what you own at any given time and the underlying risks attached to it really does change rather a lot, and that’s without getting into the massive sentiment-driven influences on price variation.

One of my favorite analogues to this is the ubiquitous reference to the “Top 1%” of wage earners. The concept is interesting and useful as a simplifying term, but like an asset class, it is by no means a static construction. Consider, for example, that more than 10% of wage-earners will, at some point in their lives, be among the Top 1%! Perhaps more impressively, more than 50% of Americans will at some point be in the Top 10%. Consider the impact that this has on a wide range of policies considered and rhetoric used — not invalidating, to be sure, but relevant.

The second class of problems stemming from the long-term path from terminology into convention is the inevitable realization by market participants that they can — and once enough people do, that they must — game the system. That’s where the coyotes and raccoons come in, but also your garden-variety professionals justifiably worried about career risk. But all of these folks hope you’re hungry for some delicious Crunchy Frog.

Fight Fiercely, Harvard!

What do I mean? Well, sometimes it’s obvious. Let’s consider the curious case of the Harvard Endowment.

A week ago, multiple media outlets reported that alumni from the Class of 1969 (“an artist, a clergyman, and two professors” one article reports, but disappointingly does not finish the joke) wrote incoming Harvard University President Lawrence Bacow to encourage him to force HMC to move half of the $37.1 billion endowment out of “hedge funds” and into ETFs tracking the S&P 500. The reason? This passive management strategy would have worked better over the last several years, and would have saved a bunch of money in fees.

It goes without saying that the alumni recommendation is just really, really terrible. Like, Fergie-singing-the-anthem terrible. It’s terrible because it would arbitrarily change the risk posture of the endowment by a massive amount. It’s terrible because it would shift what has historically been a well-diversified portfolio into a woefully underdiversified portfolio with extraordinarily concentrated exposure to the performance of common stock in large U.S. companies. It’s terrible because the confluence of those two changes would massively increase the drawdowns of the endowment, its risk of ruin, and potentially impact the long-term strategic planning and aims of the greatest research university on the planet.

But mostly, it’s terrible because the proposal isn’t passive at all. Not even a little bit. It’s a massively active roll of the dice on a single market! While alumni, executives and investors bicker over whether the portfolio ought to be “passively managed”, the origin of the term and the nonsense they’re proposing couldn’t be more at odds.

Now, you may be saying, “It’s a silly alumni letter. Most people get this.” No, they really don’t. Remember, the goofy letter was covered throughout the financial media, and they are the same media who triumphantly report the annual difference in return between literally anything and the S&P 500, regardless whether it is the return on a completely different type of security or vehicle with vastly different risk and diversification characteristics. This is how most of the world thinks about investing. This is how the damned Center for Economic Policy and Research thinks about investing, for God’s sake. People who are otherwise very smart think they’re making an intelligent point about fees when they’re really making a dumb point about asset allocation — about quantity and sources of risk. Even the aforementioned Steven Pinker contracted Gell-Mann Amnesia and retweeted an article attributing the Buffett bet between S&P 500 and hedge funds to a question of cost rather than the dominating risk differences between the two.

How do we cut through terminology confusion on an issue like this?

We ask: “What is it, really?”

If you’re being sold a portfolio based on principles of “passive management”, does your advisor or manager mean “low-cost”, does he mean “not making active bets against a global market portfolio”, or both (or, y’know, neither)? If it’s a low-cost story, what is it, really? Does it have a low headline fee, but with expensive underlying implementation using swaps or external funds that don’t get included in the stated fee?  Does it have a low headline fee that your advisor is layering high additional costs on top of? What is the asset allocation you’re being sold on? Is it implicitly making an active bet against a global portfolio of financial assets? Is it the right amount of risk? Is it taking sufficient advantage of the benefits of diversification?

If you’re being asked by a client or prospect about “passive management” or “indexing”, are you sure they’re asking you about low-cost investing? Are you sure they care whether the portfolio is avoiding making bets against market cap-weighted indices? Are you sure they care whether you’re in-line with some measure of a global market portfolio? Or are they asking you why you weren’t invested 100% in the S&P 500?

Because whatever the “real” definition of passive management, we all know that we all know that this is almost always what people mean.

Deeper down the Rabbit Hole

The fact that people really mean, “why don’t you just buy the S&P 500” when they say, “why don’t you just invest passively” tells us something else about most investors. When it comes to what they buy and what they own, and especially when it comes to conventions that manifest in indexes and benchmarks, they frequently haven’t given much thought to what it really is.

Try this yourself, with your boards, your financial advisor, or with your clients. Ask them, “What is it, really, that you invest in when you buy a stock?”

I’ve done it, so I’ll give you a preview: you’ll get a huge range of answers, usually relating to “ownership” of companies or businesses. So what is an investment in a stock, really? It is a fractional, juniormost claim on the cash flow of a company, usually denominated in the currency of the country where it has its headquarters, the price of which at any given moment is determined by the investor out there who is willing to pay you the most for it — and nothing else. It has no “intrinsic value”, no “fundamental” characteristic that can be evaluated without knowing how a hundred million others will value and perceive it. It is a risky and inherently speculative investment.

In my experience, this is not what most investors mean when they say to their advisor, “just buy me a portfolio of stocks.” What they really mean is “I want to own things I understand.” They believe that investments in businesses are simple and straightforward. Unfortunately, while the businesses and how they make money may seem perfectly sensible on the surface, the forces influencing the returns from ownership of a common stock are anything but simple and straightforward. Sure, diversification helps a lot, and there are decades of relevant data to help us build some confidence about some range of likely outcomes. There are also theories of varying quality about rational behavior in that spontaneous order we call a market. But what you really own is something whose value may confound any attempt at analysis or linkage to economic fundamentals over your entire investment horizon.

Think this is just a misunderstanding of individual investors? Think again. This is a systematic problem. Consider, for example, that every Series 7-trained professional — by which I mean most of your brokers and financial advisors — is told that alternative investments tend to be “riskier” than traditional investments. In isolated cases this is true, and it’s certainly true that there are strategies by which the complexity of so-called alternative strategies introduces new dimensions of risk — usually as a way for financial intermediaries to confuse people into paying them more. But by and large, it’s an unequivocally false statement. Still, the dimension of complexity vs. perceived simplicity dominates how investors think about risk, even though the relationship is rarely strong. Don’t believe me? Ask a client, or better yet, your financial advisor to rank the following in terms of their riskiness: (1) $100 invested in an S&P 500 index fund, (2) $100 invested in centrally cleared financial futures contracts on German bunds, (3) $100 invested in fully collateralized, centrally cleared credit default swaps on U.S. IG credit. My guess is that nearly all individual investors, a majority of financial media members and a plurality of financial professionals would put #1 somewhere other than the top of the risk list. And it’s Not. Even. Close.

As it intersects with familiarity bias/availability heuristics (i.e., we are biased in our analysis toward things that we think that we know), the tyranny of terminology becomes less insidious and more obvious in its influence. Terms like stocks, bonds, commodities or real estate have readily ascertainable meanings and definitions but mean something very different when they come out of the mouths of most investors. They mean familiarity or foreignness.  Whether we are individuals working with advisors or advisors ourselves, we must understand that when most investors say risk, they mean complexity. When most investors say simple — or something they think of as simple — they mean “low risk.” These are dangerous misconceptions.

Crunchy Frogs

And friends, any time there’s a dangerous misconception, there’s someone in the financial services industry poised to weaponize it. Plenty of Crunchy Frogs to go around, you see.

In every sub-field of money management, the name of the game is benchmark arbitrage. It’s a game played in three parts: risk layering, benchmark selection and multi-benchmarking.  In each case, the affinity investors have for the comfort of indices makes them susceptible to marketing and fee schemes that have the potential to cause them harm.

Risk layering is the oldest of the three games. I wrote about it last year in I am Spartacus. The basic premise here is to select a benchmark that will feel attractive, familiar and conventional, and then to take additional risk on top of it to either (1) earn a better fee for the return generated by that risk or (2) generate better-looking performance to improve marketing potential. This IS the business model of private equity buyout funds, who since the massive fund raises and valuation increases of the mid-2000s, now take your cash, buy a company at a premium, layer on debt and sell it a few years down the line without having really done much of anything else. They’re not alone. Keying on the intellectual attraction of an “absolute return hurdle”, many so-called hedged and market neutral funds take on credit, equity and other risks beyond what exists in the benchmark, happily collecting incentive fees on garden-variety sources of return. Long-only funds do this too, of course. Most actively managed funds tend to buy higher beta, higher volatility stocks, and nearly all are smaller capitalization than the benchmark they are measured against.

Benchmark selection is often just a variant of risk-layering, but where the fund manager tries to control both the measurement and the measuring stick. Think of this like “venue-shopping” in the criminal justice world. Have you hired an international manager benchmarked to the MSCI EAFE Index? They do this. I don’t know who you hired, but they do this. They always have 5-10% in emerging markets stocks, don’t they?  There’s a reason they didn’t select the MSCI World ex-US benchmark, folks.

As for multi-benchmarking, well…I hate to tell you, but if you have ever hired a money manager, a financial advisor or even an in-house investment team, you’ve seen this one, even if you didn’t notice it. It’s very simple: you pick two benchmarks, and then you make sure you’re always positioned between them. And that’s it. Sometimes one of the benchmarks is a peer benchmark (e.g., Morningstar, Lipper, eVestment peer group, Wilshire TUCS, Cambridge for the alts folks), or sometimes it’s a “style” benchmark (e.g., Value, Growth, High Dividend, Quality, Low Vol, etc.). But the objective is to always be able to point to something that you’re outperforming. A lot of this is well-intentioned and human, and there’s often a good reason to do it. But if you’re not looking out for it, it can confound.

And that’s kinda the point.

We can’t avoid convention, or the taxonomy that emerges naturally from an industry like ours. Nor should we want to. It helps us have conversations with each other. It helps us focus on Things that Matter instead of getting bogged down in details. But if we are to be successful, we must recognize the influence it has on us, our clients, our advisors and other investors. My advice?

Try to understand what your clients really think their investments are. Know what they really mean when they ask why you are or aren’t doing something.

Know what your advisors and managers think something is. Ask questions. Don’t assume based on terminology, and don’t be steamrolled by jargon.

Know what the things you own actually are, and build a risk management program to ensure that the baser temptations of people in this industry don’t cost you or your clients money.

As we delve further into alpha in a “Three-Body Market”, this last point will come up a lot. You can’t seek alpha if you don’t really know how to measure it. Except for the Postmodernists. Y’all can still tell us how it makes you feel.

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I Am Spartacus: Things that Don’t Matter #1

I am Spartacus!

Herald: I bring a message from your master, Marcus Licinius Crassus, commander of Italy. By common of His Most Merciful Excellency, your lives are to be spared! Slaves you were, and slaves you remain. But the terrible penalty of crucifixion has been set aside on the single condition that you identify the body or the living person of the slave called Spartacus.

Antoninus (Tony Curtis): I am Spartacus!

Other Slaves: I’m Spartacus!

— Spartacus (1960)

We are all active managers, friends. The sooner the better that we realize this and start focusing on the when and why it makes sense for investors, instead of wishcasting “good environments for active management” that don’t exist. While we may not be obscuring each other’s identities, it’s probably time for more of us to stand up and say, “I am an active manager!” Although, I suppose it is worth mentioning that shortly after this scene, Spartacus is forced to kill his best friend before being crucified.

“Active management is a zero-sum game before cost, and the winners have to win at the expense of the losers.”

— Eugene Fama, Ph.D., Investment News, October 7, 2013

Walter Sobchak: Am I wrong?

The Dude: No, you’re not wrong.

Walter: Am I wrong?

The Dude: You’re not wrong, Walter. You’re just an asshole.

Walter: All right then.

— The Big Lebowski (1998)

“You heard about it? Yeah you had to.

Mm hmm I know you changed your mind,

You ain’t the only one with bad news.

I know that it made you feel strange, huh?

You was right in the middle complainin’

and forgot what you was cryin’ about.”

— Mystikal, “Bouncin’ Back” (2001)

Ahchoo: Look, Robin, you don’t have to do this. I mean, this ain’t exactly the Mississippi. I’m on one side. I’m on the other side. I’m on the east bank, I’m on the west bank. It’s not that critical.

Robin: It’s the principle of the thing.

— Robin Hood: Men in Tights (1993)

It seems like every few years the debate on active vs. passive management comes back in full force — not that any of this is new, of course. DFA, Vanguard, and brilliant investors and writers like Charlie Ellis have been shouting from the mountaintop about what a waste of time active management is for decades now. So why the breathless excitement from the financial press on the topic this time? Mostly because they haven’t the faintest idea what they’re talking about.

Don’t mistake me: Charlie Ellis isn’t wrong. Jack Bogle isn’t wrong. Gene Fama isn’t wrong. But the basis for the broader active vs. passive debate is misleading at best, and outright fraud at worst. Let’s get a few objective, unequivocal facts out of the way about active management:

  1. There is no such thing as a “good” or “bad” environment for active management.
  2. Everyone — including you, dear reader — is an active investor.
  3. Costs matter. The rest of this debate is a waste of time.

This is why the debate over active vs. passive is #1 on my list of Things that Don’t Matter.

The myth of the good or bad environment for active management

Most investors have at least a passing familiarity with the notion of the zero-sum game. It is an academic and logically sound construct which says that if one investor is overweight or long a particular security relative to its market capitalization weighted share of that market, it stands to reason that another investor must necessarily be underweight or short.

This is true to the point of tautology, and there’s no disputing it. It’s true, and it’s used as the fundamental, deterministic argument for why active management can never  work. If every winner is offset with a loser and everyone is paying fees, over time the house is going to win. It’s also why Dr. Fama has famously and accurately said that if the data shows that active management is working, then the data is wrong.

But if this is the case, how it is possible that there are “good” or “bad” environments for active managers or stock pickers? Wouldn’t every environment just be equally bad to the tune of the drag from fees and expenses? If so, why are we talking about this historically bad period for fund managers?

The reason we are talking about it is that practically every study, allocator, advisor, researcher and article covering this topic considers passive management in context of a particular benchmark or index. However, not every pool of assets benchmarked against an index is necessarily seeking to outperform that index on an absolute basis. Even more to the point, these pools certainly don’t confine their investments to constituents of that index.

If you weighted each of the benchmarks used by investors, funds and institutions by the value of each of those pools of capital, you would end up with something that looked very different from the market capitalization of the world’s financial assets. By way of the most obvious example, I suspect that the total value of pools of capital that benchmark themselves formally against the S&P 500 Index (“S&P 500”) vastly exceeds the market capitalization of the S&P 500 itself. The value that does so informally is probably many multiples of that.

The way that this plays out in practice is surprisingly consistent. Consider a U.S. large-cap strategy. There are four biases that are ubiquitous — uniform might be nearer the mark — among both actively managed mutual funds and institutional separate accounts:

  • investments in small- and mid-cap stocks
  • investments in higher volatility / higher beta stocks
  • investments in international stocks
  • cash holdings

In other words, there is no good or bad environment for active management. There are good or bad environments for the relatively static biases that are almost universal among the pools of capital that benchmark themselves to various indices.

If you are an allocator, financial advisor or individual investor, you may have heard from your large-cap fund managers during the first half of 2016 how bad an environment it was for active management. Maybe they said that the market is ignoring fundamentals or that everything is moving together or that the market is adopting a short-term view.

That’s about 50% story-telling and 50% confirmation bias. It’s also 0% useful.

In an overwhelming majority of cases, that environment is simply one in which either small-caps underperformed or high beta / high-risk stocks did.

From the same investor vantage point, the second half of 2016 probably looked different. We often say that we don’t have a crystal ball, but I have a very reliable prediction about your annual reviews with your U.S. large-cap managers. They may inform you that “fundamentals started mattering again” in the second half of the year. The market started paying attention to earnings quality and management decisions and [insert generalization that will fill up the allotted time for the meeting here].

No they didn’t.

Small-cap and high-beta or high volatility stocks bounced back really hard. When you do your review with your active small-cap managers, you may be surprised when they, on the other hand, are doing so poorly relative to their benchmarks. Why? Because small-cap managers manage portfolios that are typically above the market cap of the Russell 2000 Index (“Russell 2000”) and nearly uniformly underperform when small-cap is trouncing large-cap.

Let’s take a look at how and why this is. The chart below splits up every month from January 2001 through January 2017 by the spread between the return of the Russell 2000 and the S&P 500. The chart plots the average excess return of each of the funds in the Morningstar Large Blend category against the S&P 500 by how pronounced the difference between small- and large-caps was for the period. In other words, what we’re looking at is whether large-cap funds have done better or worse vs. the S&P when large-caps are outperforming small-caps in general.

The results are stark. In the bottom decile of months for the large vs. small spread (i.e., the 10% of months where small-caps do the BEST), large-cap blend managers outperform the S&P by an annualized rate of just over 4%. By contrast, in the top decile for large-cap vs. small-cap, they underperform by an annualized rate of nearly 5%!

Those bad environments for stock picking your fund managers are so fond of telling you about? They’re only bad because almost all of your active managers are picking riskier stocks and putting small- and mid-caps in your large-cap fund.

Sources: Bloomberg, Ken French U.S. Research Returns, Morningstar as of 01/31/17. For illustrative purposes only. Past performance is no guarantee of future results.

Unfortunately for those of you who breathed a sigh of relief in August and September of 2016 because your active managers were ‘working’ again, this doesn’t necessarily mean your fund manager had a flash of brilliance from the patio of his Southampton rental. Low beta just spat up all the excess returns it generated in the first half of the year.

These kinds of biases are not confined to large-cap U.S. equity managers, of course. As mentioned, your small-cap managers are usually going to get smoked when small-caps are roaring. Your international equity managers are all buying emerging markets stocks around the edges of their portfolios (that’s why they were geniuses until the last three years or so, and now we think they’re stupid). Your fixed income guys are often just about all doing “core plus” even if they don’t say so on the wrapper. Your long/short equity and event funds have persistent sectoral biases.

Every category of active management has its own peculiar but fairly persistent bias against its benchmark.

OK, so active managers have consistent biases. So what? It still rolls up to the same zero-sum game, right? Yes, but it’s useful to think about and understand what’s going on underneath the hood. Namely, since we know that actively managed large-cap mutual funds and institutional separate accounts are usually underweight mega-caps, large-caps and lower risk stocks relative to the passive universe, we must fill in the gap: who is overweight these stocks to offset?

The answer is, well, strategies other than large-cap strategies, or ones that are not benchmarked to the S&P 500 or Russell 1000 Index (“Russell 1000”). That can include a wide variety of vehicles, but at the margin it includes (1) hedge funds, (2) individual or corporate holders of ‘un-benchmarked’ securities portfolios and (3) portfolios that are targeting a sub-set or variant of the large-cap universe. Clearly it also includes all sorts of strategies benchmarked to other markets entirely, one of the most common examples being multi-asset portfolios. As illustrated in the exhibit below, the S&P 500 is very obviously not completely owned by pools of capital that are benchmarked to the S&P 500.

For illustrative purposes only.

Hedge funds provide us with the most exaggerated example of one of the ways this happens. Let’s presume that large-cap mutual funds are underweight low volatility mega-cap stocks to the tune of $50 billion.

Now let’s examine two cases — in the first case, $25 billion in hedge fund capital is deployed to buy all $50 billion of that on a levered long basis. In the second case, $100 billion of hedge fund capital is used, meaning that the funds chose to hold 50% cash and spent the remaining 50% on the mega-cap stocks.

If the S&P 500 is up and a particular publication wants to talk about hedge fund returns, they’re going to talk about the first scenario as a heroic period of returns for hedge funds. In the second scenario, hedge funds are a scam run to prop up the richest 1%. Neither is true, of course — well, not on this basis alone, at least — because the benchmark isn’t capturing the risk posture that an investor is using as part of its asset allocation scheme to select that investment — in this case a long/short hedge fund.

Consider as well that many of the strategies that are ‘filling in’ for active large-cap managers’ underweights to Johnson & Johnson and ExxonMobil do so in tactical or multi-asset portfolios, many of which are going to be compared against different benchmarks entirely. Still, others may be executed under minimum volatility or income equity mandates. When you consider that the utility functions of investors in these strategies may be different, and that one investor may reasonably emphasize risk-adjusted returns rather than total returns, or that two investors might have meaningfully different needs for income in context of their overall financial situation, the argument starts to get very cloudy indeed.

There is no such thing as a passive investor

So when faced with an income objective like the example above, the response of many in the passive management camp is typically some form of, “Well, just buy more of a passive income equity fund, or move more money to bonds.”

It is this kind of argument that exemplifies why this active vs. passive debate feels so phony, so contrived. As it is too often applied, the mantra of passive management emphasizes avoiding funds that make decisions that many those allocators/advisors/investors will then make themselves and charge/pay for under the guise of asset allocation.

If a fund manager rotates between diversified portfolios of stocks, bonds, credit and other assets based on changing risks or income characteristics, he gets a Scarlet A for the vile, dastardly active manager he is. If an investor or allocator does the same thing by allocating between passively managed funds in each of those categories, he posts about it on Reddit and gets 200 up-votes.

If a fund manager invests in a portfolio of futures (lower cost passive exposure than ETFs, by the way) to reach a target level of risk and diversification without trying to pick individual securities at all, just go ahead and tattoo the “A” on their deserving forehead in permanent ink. If an investor or allocator does the same thing to build a portfolio that is equally or more distinct from a global cap-weighted benchmark using more expensive ETFs, we can only celebrate them and hope they pen a scathing white paper on the systemic risks embedded in risk-targeted investment strategies.

Everyone is often doing the same things — and usually paying for it — in different ways. To paraphrase Ahchoo (bless you), some of you are on the east bank and some of you are on the west bank. But this ain’t exactly the Mississippi. It’s not. That. Critical.

What IS critical is understanding why this debate occupies such an august (notorious?) spot on this list of Things that Don’t Matter. And here it is: I am fully confident that not a single passive investor owns a portfolio of global financial assets in the respective weights of their total value or market capitalization. Instead, they allocate away from the cap-weighted global financial assets standard based on (1) their risk appetite, (2) in order to better diversify and (3) to satisfy certain personal goals around income and taxes.

Let’s put some figures on this. Using a basic methodology from public sources (while acknowledging without having access to his letters that Paul Singer has adopted a similar approach) as of the end of 2015 or 2016 — we’re talking big numbers here, so the timeliness isn’t that important — global investable assets look something like the pie chart below.

Sources: BIS, Savillis, World Bank. For illustrative purposes only.

Yes, there’s overlap here. Yes, if you added in capital raised to invest in private companies it would add another 1.2% to equities, and including insider holdings in private companies would expand this more (although debatably). It also doesn’t include a range of commodities or commodities reserves because of the (generally) transitive nature of the former and indeterminate nature of the latter. But it’s good enough for our purposes. So does your portfolio look like this? If not, let me be the first to initiate you into the club of active managers.

Every investor is an active investor when it comes down to the major dimensions of asset allocation: risk, diversification, income and liquidity. Eliminating strategies as “Active” because they seek to manage risk, improve diversification, increase income or take advantage of greater (or lesser) liquidity is wrong-headed at best and hypocritical at worst. Most of all, it harms investors.

The S&P 500 example is not universally applicable, of course. Public large capitalization stocks are well-covered by indices, and so index funds that track the S&P 500 or Russell 1000 are generally sound examples of vehicles seeking to avoid the pitfalls of the zero-sum game. That is not always the case, however.

One example of this I like to use is the Alerian MLP Index. It is a perfectly acceptable representation of the energy MLP market, and deserves credit for being the first to track this growing asset class. It tracks 50 key constituents with around $300 billion in total market cap. The overall universe of listed midstream energy companies, however, is closer to 140-150 and sports a market cap of nearly $750 billion. There are several index funds and ETFs that track the index, and dozens of so-called actively managed funds that include a higher number of securities that look rather more like the cap-weighted market for energy infrastructure!

A more mainstream example of this might be the Dow Jones Industrial Index, famous for being used by CNBC every day and by a professional investor for the last time in the mid-1950s. This index of 30 stocks covers only a fraction of the breadth of listed stocks in the U.S. with meaningfully different characteristics on a dozen dimensions, and is tracked by a “passive” ETF with roughly $12 billion in assets. Meanwhile, lower cost large-cap mutual funds and accounts with 120 holdings built to deliver higher than typical income at a lower volatility than the market are “actively managed.” To make matters more complicated, many asset classes that are a meaningful — and diversifying — part of the cap-weighted global market simply do not have passive alternatives.

There is a wonderful local convenience store chain called Wawa where I went to college. I had a…uh…friend whose laziness was so well-developed that his diet was entirely driven by what was available at Wawa. If they didn’t have it, he didn’t eat it. Now, there are all sorts of delightful things to be had there, so don’t get me wrong. But if you’ve got something other than hot dogs, ham sandwiches or Tastykake Krimpets on your mind, you’re out of luck.

I’m sorry to say that the Index Fund Wawa is fresh out of vehicles owning securities issued by private companies, listed securities in certain niches of the markets (e.g., preferred securities in real estate) with meaningful diversification and income benefits, less liquid instruments and others unable to be held in daily or continuous liquidity vehicles. Many of these strategies have significant diversification potential and roles within portfolios. Many are often highly effective tools for adding income, efficient risk mitigation or other characteristics to portfolios. Many may even have higher expected returns or risk-adjusted returns. But you’ll have to leave the Wawa to get them.

None of this even begins to venture into hedge funds and other alternative strategies, and how they ought to be considered in context of the overall debate. To be sure, the answer is probably to observe that the same criticisms and defenses that can be brought to bear against (or on behalf of) active management apply to strategies like this as well.

But to a great extent for hedge funds (and to a lesser one for traditional strategies), there are potential sources of return that may be consistently exploited that have nearly the same empirical and fundamental underpinnings of market exposure as a source of potential return. At their core — and consistent with how we discuss them in Epsilon Theory — they are almost universally an expression of human behavior. Whether expressed through premia to value, momentum or carry premia, or else biases investors have toward quality, lottery payoffs, liquidity and the like, the great irony is that the most successful actively managed strategies are those that exploit the fact that many investors are often drawn to the appeal of active management under the guise of ‘beating the market.’

For this reason, it is somewhat baffling to see the disdain with which passionate passive investors treat many alternative strategies. If we believe that active management can persistently lead investors to predictable bad outcomes driven by understandable behavioral biases and responses to information, why would we be averse to approaches that seek to exploit this? Most investors can, however, see the forest for the trees on this issue. That is the reason why, despite the contraction in actively managed strategies more broadly, most projections for the market for liquid alternatives posit a doubling of assets in the space between 2015 and 20201.

1Both PWC and McKinsey’s work on this topic comes highly recommended.

Costs matter (and the rest of this debate is a waste of time)

Now admittedly, I have waited quite a long time to talk about one of the principal concerns around many actively managed strategies: cost.

In coming around to this critical consideration, it is worth circling back to the indisputable fact that Bogle, Fama and Ellis are right. Trying to beat the market in most markets by being overweight the right stocks and underweight the right stocks is a loser’s game. Doing that and paying fees for it makes it an expensive loser’s game. The reality is that investors need to put the pitchforks away and ask themselves a set of simple questions when considering actively managed funds:

  • Portfolio Outcomes: For a fund that is making active decisions that I would be responsible for in my asset allocation, like risk targeting, biasing toward income and yield or improving portfolio diversification, do the benefits justify the cost?
  • Incomplete or Non-Existent Indexes: When an active fund provides better diversification or coverage of an opportunity set, or covers an investment universe that is not investable through passive solutions, do the benefits justify the cost?
  • Exploiting Bad Behaviors: When investing to exploit the behaviors of other investors who are trying to beat the market to increase returns or improve risk-adjusted returns of my portfolio, do the benefits justify the cost?

It shouldn’t be any surprise that this will often lead you to the same conclusion as a passive management zealot, because adding value that justifies the cost on the above dimensions is still really hard. Active management should be evaluated with the same critical eye and cost/benefit analysis every one of us use when we make active decisions in our portfolio design and asset allocation. But because it won’t always be the case, the process matters, and the code you follow to draw your investment conclusions matters.

The active vs. passive debate, on the other hand, does not. Enough.

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