Renaissance Requires Reinvention

One of the best stock picking newspaper columns, the Wall Street Journal’s Ahead of the Tape, is winding itself down.

It’s not because my friend Steven Russolillo wasn’t doing a great job – he was. Rather, it’s because this is simply not how large numbers of people invest anymore.

Similar to being a stock picker, taking a view on a specific company ahead of its results is fraught with risk. Even if the company beats expectations, that doesn’t mean the stock goes up. Trying to predict how a stock will trade in the short term is generally no better than a coin flip.

Such is the conundrum that both professional and individual investors (and Tape columnists) face. It also is a perfect example of why picking stocks has become a dying art. In a 15-year period ending in December, more than 90% of U.S. equity fund managers trailed their respective benchmarks…

The Tape stuck with stock picking, with some helpful context, but most investors gave up on trying to beat the market. Some $1.5 trillion has poured into passive mutual funds and exchange-traded funds over the past three years through April, while $650 billion has left actively managed funds…

I’ve been talking about this phenomenon for over five years now.

A lot of people in the industry were saying that this was a cyclical thing and would someday reverse itself – indexing, passive investing and ETFs would someday become out of favor and stock pickers would once again distinguish themselves and look like the hottest game in town.

I don’t think so. I think it’s secular.

It’s hard to see how a large number of active managers will once again be able to string together multi-year winning track records given that the low hanging fruit has already left the market. There’s been a case made that with less people trying to pick stocks, alpha would become more plentiful, like a restocked stream that people stopped fishing in. I think that’s backwards. As more mom and pops exit the card game, and take their easily harvested mistakes with them, we’re left with only the best professionals still at the table, ripping each other’s throats out.

I guess I would say that active isn’t going to die, it’s just going to shrink and possibly look a lot different from what it looks like today.

Morningstar’s Jeffrey Ptak got a look at a new format being attempted by active management stalwart AllianceBernstein. They’re launching funds in which the manager only gets paid a Vanguard-esque 10 basis points for meeting or trailing his or her benchmark. The manager gets paid more, on a curve, for exceeding. I’m rooting for them. It’s time for experimentation. But I also doubt they’ll be able to consistently deliver. Some years they’ll earn the higher fee and some years they won’t. You won’t know in advance which kind of year it’s going to be for the AB fund you purchase.

Also, the tax consequences of turnover aren’t addressed by this structure. It also opens up a new can of worms in terms of manager behavior with a shifting incentive hanging in the balance. Will more risks be taken toward the end of a calendar year in which an AB manager is awfully close to the next rung of performance fees?

Remember: Incentives matter.

When people ask me what I think the future of active stock picking is, I tell them heavily concentrated portfolios with huge tracking error – to the upside and the downside. A lot more Wild West than things have become, but a throwback to the old days when managers weren’t obsessing over benchmarks in order to please consultants in order to get included in style boxes and model portfolios. Closet indexing wasn’t typical of the 70’s and 80’s, because people weren’t as heavily focused on the index as they are now.

Jason Voss and C. Thomas Howard at the CFA Institute’s Enterprising Investor blog have been writing about what’s necessary to bring about a new Active Management Renaissance. But first, we need to understand how we got here:

Benchmarks were originally constructed to measure performance after the fact. Sadly, they have become targets for buy-side research analysts and portfolio managers to manage to before the fact.

To enforce this, investment intermediaries have developed measures — style boxes, style drift, and tracking error — that are entirely arbitrary. Why? Because, again, they want managers to adhere to a niche strategy as part of an overarching asset allocation plan.

I gave some money to my old friend Eddy Elfenbein when his Crossing Wall Street ETF launched last fall. He did well and I will probably him some more.

He’s got the first actively managed ETF with a variable management fee built into it (his product was launched through Noah Hamman’s AdvisorShares fund family). He’s doing between 20 and 30 of his favorite stocks, which will either be very good or very bad in different market environments. But overall, he’s not snuggling up to the Russell 3000 or the S&P 500. I have no way of knowing whether or not what he’s trying to do will work, I only know that it won’t look exactly like an index fund I can buy for approximately zero dollars.

Here’s Voss and Howard again on concentration:

Studies show that buy-side analysts are quite good at security selection: Take, for example, the high levels of accretive alpha of their highest conviction/largest positions, as measured by ex-ante relative portfolio weights. Moving down the relative weights, performance worsens, with holdings beyond the top 20 generating negative alpha. In other words, most portfolios are overdiversified and research shows that hurts performance.

What’s interesting is that, because Eddy doesn’t focus on the benchmark in terms of how he talks about his approach, I have never even once looked at CWS’s performance against it, only absolutely. There’s a benefit to this sort of reframing that I should probably think more deeply about.

There should be more attempts at innovation like what we’re seeing from Eddy and AB. Something will eventually click.