Sunday, August 14, 2016
Priest et al., Winning at Active Management
The first task of the authors is to make the case for active management in the face of the industry’s pretty grim performance numbers. Even before fees, a minority of U.S. large-cap core equity managers managed to outperform the S&P 500 over one year (42%), three years (48%), and five years (46%). Only over a ten-year time horizon did a majority outperform (69%).
The authors’ argument is that the real-life insights of behavioral economists have effectively defeated what “started off as an ironclad theoretical case for passive management.” (p. 85) Even so, the strongest conclusion this argument can reach is that successful active management is possible.
Several factors work against active managers. Periods of higher correlation and lower dispersion are challenging for managers, as are times when the stocks of lower-quality companies outperform those of higher-quality companies. Active funds also experience a drag from cash holdings. And, of course, they fall victim to the paradox of skill. As Mauboussin described this paradox, as participants in an endeavor become more skillful as a whole, luck becomes an increasingly important component of any one participant’s results.
Theoretically, active managers can outperform stock market averages because behavioral biases create market inefficiencies. Practically, “most managers have not been following an approach that is likely to work.” The authors contend that “capturing the impact of stock-specific inefficiencies requires a disciplined process that (1) understands the forces that create an inefficiency, (2) captures it by ‘casting a wide net’ across stocks that are likely to be affected, and (3) properly structures the portfolio so as to filter out the impact of any factors (e.g., size or industry effects) for which the manager currently has no forecast, and which might otherwise swamp the excess return generated by the inefficiency that the manager is trying to capture.” (p. 106)
The investment philosophy of the authors’ firm is that “cash flow is the origin of value in stocks, and that forecasts of cash flows should be the basis for security selection.” (p. 133)
The authors also address the role of technology in investing. Will computers eventually take over the world of investment management? The authors not unexpectedly take the position that “investing is too important for robots alone.” Instead, they are, in the words of one of their firm’s recent initiatives, “racing with the machine.”
Three appendices to the book present selected articles and white papers of Epoch Investment Partners, a review of principles of valuation for financial assets, and a case study about disclosure written by Jack Treynor in 1993.