Arguing for a Active Investment Strategy
A recent study by Peter Mladina, Director of Research of Waterline Partners, which advocated the taxable investor own primary passively managed equities and other passive investments, is not without flaws.
The author concluded an active manager needed to show outperformance of 380 basis points (his “triple net” alpha) over a passive strategy to essentially break even in terms of similar after-tax return.
I have found most active strategies fail due to a misjudgment of risk (cost of equity capital) and incorrect definition of free cash flow. In this case a passive strategy is preferable. However, with more precise calculations of these variables sustained outperformance can be achieved.
I see little to nothing new in the paper’s general conclusions. A passive strategy, of course, works in general, as the universe cannot outperform itself when fees and other costs of an active strategy are deducted. There are other advantages of the passive strategy mentioned at the conclusion of this response. Of course, the paper is based on historical and normal results, which may be at odds with prospective happenings.
Major Reasons for Active Manager Underperformance
Security analysts, in general, do not understand-let alone quantify- the deep and often buried list of risks firms confront. A thorough insight into risk forms the basis of the discounting mechanism (cost of equity capital). A lack of awareness of these “hidden” risks (i.e. Moral obligations, derivatives, mergers or other business combinations, financial structure, pension and other benefits, taxes…) forces a valuation that is not consistent with, nor reflect the true valuation of the entity. My response here is not meant to be too great an advertisement for CT Capital but our detailed evaluation of risk as a key factor in what I believe will lead to outperformance vs. benchmarks and other active managers. I would encourage you to ask security analysts, equity managers and other investors and consultants how they arrive at the discount rate, and what they believe it is meant to capture (correct answer: risk to prospective free cash flows).
Most security analysts, investors, corporate finance analysts, and investment bankers do not understand how to measure free cash flow. I have worked all sides of corporate finance and investment advisory, and by failing to account for, including proper (re)classification and adjustment of items in the statement of cash flows, income statement, and footnotes, outperformance can only take place through luck, and I do not believe in luck as a fitting methodology outside the casino. The free cash flows are the income to the investor and its yield forms the basis of metrics used in capital decisions, including the margin of safety between the cost of capital.
So, if risk and free cash flows are not properly measured, a passive strategy makes sense. Ask yourself, what makes Warren Buffet so smart? The answer is simple: he buys assets that meet the above criteria, even though even he sometimes gets off the beaten track with regard to risk.
Back to the Paper…
I find fault with several of the assumptions in the paper. For example, the author’s “required triple net-alpha,” is derived thru a backed-into calculation after other variables are known. Unfortunately, those variables are at odds with the costs and expenses available to most large investors. Building upon the 7.77%, (which he uses as the average historical return) across the board does not recognize these more realistic assumptions and thus throws off the remaining calculations that differ with the passive strategy returns.
Let me also point out even an active strategy of a diversified portfolio based on ETF’s finds expenses much closer to the passive strategy expense other ratios’.
In some ways the author’s entire argument is circular as it assumed a manager would need to outperform by 380 basis points in order to make up for active management costs. However, those higher costs are a result of taking advantage of opportunities that a passive fund cannot (e.g. managers do not trade more for the sake of racking up higher commissions but because they believe they have superior information).
The 1.35% expense ratio, 0.89% in transaction costs, and 94% turnover, are over three times that at CT Capital LLC, as we trade at 1 cent per share with moderate turnover. I believe all three estimates are considerably higher than necessary to achieve outperformance. Mutual funds that incur research costs via commissions often do pay the higher fees quoted by the author, however this is an unnecessary expense avoided by investment advisors who use their own research teams and models. The author also quoted studies that were themselves faulty.
Regarding the tax assumption, as investment advisors tend to hold their unrealized gains over longer holding periods than realized losses, this assumption is also exaggerated.
Also, the 7.77% result used as the basis, is the return before transaction costs. I have not seen advisors report this way, although I understand what the author is trying to get at-the added return over passive- in actuality, it is unrealistic.
When adopting more practical expense, transaction costs, and tax assumptions, for a moderately trading investment manager, the triple net alpha is cut to about 73% less than the author’s ’ 380 basis point triple net alpha, or 1.03%. An investment manager in equities that can consistently outperform by this magnitude would be roughly equivalent to the author’s passive results. To believe a gross annual 380 basis point return is required over a passive strategy is unrealistic and not supported by fact and reality existing in the marketplace. I have recently seen active managers charge very low fees, not to distant from passive fees, for ultra large accounts. With worldwide economic growth slow, it is in this direction fees and expenses are headed. Actuarial assumptions have rarely been met over the past decade, and cost reduction is the preferred solution.
Conclusion
The passive strategy will make sense for a long time to come, although the quoted required gap (triple net) is exaggerated. Faulty security analysts, the large benchmark indexes being of considerably higher quality than the equity market as a whole, the taking of undue risks by the investment manager universe, and the identity of the whole not being greater than itself, are the reasons. On the other hand, active fees and expenses are incontrovertibly headed down and will soon provide stronger competition with passive products, including ETFs and indexing.
Unquestionably, a clandestine reason for the growth of indexed products has been the guidance and education of security analysts. Historically, except for perhaps the CFA program, which even itself is lacking, analyst training is constituted more of on-the job instruction than what is really needed, but admittedly impossible to pull off-that of on the job training at various firms in the industries covered by said analysts.
However, if investment consultants, pension sponsors, financial journalists and other advisory firms find the superior analyst and process, extreme value will be provided over the passive strategy. I have seen firsthand, over four decades, how an active strategy can earn returns many times that of a passive strategy, taking into account the greater fee and tax effects.
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