The Science of Active Investing
December 15, 2018
A volatile market is a chance for the (mostly) active manager to deploy its secret weapon: discernment. #marketvolatility #activemanagement #cwcculture #chrisweil #activemanagers #activediscernment #welldiversifiedactiveinvestor
A Word from the Editor
By Kit-Victoria (Weil) Wells – Culture & Communications Officer
As we ring in the Holiday Season - with investors’ mettle being tested by the capricious volatility of the markets - we pine for the magical wish fulfillment that is often associated with this time of year. But after decades and decades in the investment business, we remind ourselves that markets go up and markets go down. In the spirit of focusing on opportunities provided by these types of markets, CWC Portfolio Manager Mike Hubbert and CWC Financial Advisor (and Venture Capital/Private Equity Division Head) Matt Weil, provide Part 2 of their article “Why We Are (Mostly) Active Managers” touching on, among other things, the value to be found in active management in times like these.
These types of market swings can be unnerving and raise investment questions. Please know that CWC’s team of financial and investment professionals stands ready to assist you in navigating your financial life. We at Christopher Weil & Company, Inc. wish you and your families a joyful and peaceful Holiday Season.
Why We Are (Mostly) Active Managers – Part 2
By Michael Hubbert, CIMA® & Matthew Weil, JD
In our Mid-Third Quarter 2018 Newsletter published last September, we took an initial look at the topic of “passive” versus “active” investing and gave a first-order answer to the question of why we at CWC are, mostly, active managers. With this continuation of that discussion, we look a little more closely at the science and art behind investing and make the case for why we currently do not allocate more of our and our clients’ money to passive vehicles.
It is not surprising that over the last several years there has been an incredible proliferation of passive vehicles, given how these lower-fee passive vehicles have effectively (and, seemingly, effortlessly) captured the lion’s share of a remarkably persistent bull market following the financial crisis of 2009. The hypothetical investor with the foresight and good timing to simply plough a goodly sum into an S&P index fund (for example, the SPDR S&P 500 ETF or “SPY”) at the depth of the Great Recession, who also had the fortitude to leave the investment untouched through various ups and downs since, would have seen performance something like the darker black line in Figure 1. (You can ignore the other lines for the moment.) There were some bumps in the road (notably mid 2010, the second half of 2011, mid 2015 to early 2016 … and, of course, this last year), but the general trend depicted here is undeniably up.
What people tend to forget, however, as they consider SPY’s performance over the last nine or so years is what the previous decade looked like. As shown by the black line in Figure 2, the 11 years starting January 2000 were an unpleasant and – ultimately (depending on when you got onto the ride) – unproductive roller coaster for SPY, which ended up essentially flat for the period.
The fact that a sector or index that looks good in one timeframe may be less attractive in another is more an argument for diversification than an argument for active management per se. But (as we noted in the earlier installment of this discussion) one component of active management is active decision-making regarding how to allocate investment dollars. And when one sector seems to be going up with no end in sight, that is exactly the time an active manager can help an investor keep the importance of asset diversification (and the inherent risk of piling in to popular and, potentially, overvalued positions) front of mind.
Figures 1 and 2 also illustrate another point relevant to the discussion of active versus passive investing: depending on the timeframe you consider when you compare investments styles, (almost) every dog has its day.
It is striking how SPY, which did so well in the last nine years, was flat-to-down in the previous period. And it turns out that the “value” component of the S&P 500 (represented by SVX) did almost as well in the most recent period, but relatively better in the earlier one. (15% is better than negative 1.45%, after all.) QQQ (which is an ETF that tracks the NASDAQ) did spectacularly over the last nine years, and abysmally through the aughts (losing almost 42%). Emerging markets outperformed the other three smartly in the aughts, but have underperformed by comparison in the last nine years.
It is true that prominent voices have raised doubts about the long-term benefit of active investment management. No less a figure than Warren Buffet – the fabled “Oracle of Omaha” – has lauded the benefits of dollar-cost averaging into an S&P 500 index fund as a safe and effective way for small investors to capture market performance. Of course, for Buffet, this is something of a “do-as-I-say” recommendation, as the approach of his own fund (Berkshire Hathaway) and his personal style of investing both belie the notion that everyone should invest all their money in the full S&P 500. (If you doubt that Buffet is no indexer, you need look no further than a recent report showing the Berkshire Hathaway portfolio was 35% invested in international banks and a full 26% in the stock of a single company, Apple.)
Mr. Buffet’s musings notwithstanding, actively managed portfolios can clearly outperform index funds and ETFs (or a combination of these two). The AMG Yacktman Fund (the green line in Figures 1 and 2) is one prominent piece of evidence for this proposition. (Yacktman’s total return from January 2000 to November 2011 was almost 250%, while the S&P was flat; and even as the S&P has boomed since March 2009, Yacktman has boomed even more, up 426%.) While this evidence is purely anecdotal, it is consistent with our experience that, over a reasonable period, portfolios that are largely actively managed, either by direct ownership of securities or through mutual funds, can enjoy a clear edge.
There are at least two reasons that active managers can do better in practice notwithstanding the theoretical attractiveness of simply “buying the market.”
First, the models used to show the benefits of “passive” investing usually focus on the lower fees charged by index funds (as compared to their actively managed brethren). These models assume a steady state comparison – x dollars invested on y date and held for a term of z years – but the real-world experience of investors rarely fit these simplistic models. The timing of “ins” and “outs” turn out to be a far more crucial factor than the fee in determining overall investment outcomes. In our real-world experience, the difference made by a marginally higher management fee is less material to overall investing success than careful attention regarding what to invest in and when (and, equally importantly, when to stay in the markets rather than “heading for the hills”). Bad decisions made in times of high volatility can have long lasting consequences and we, as active managers, strive to mitigate such situations for ourselves and our clients.
Active managers are often able to take steps to dampen volatility. While most investors think they will be able to tolerate long periods of declining and/or volatile markets, a great deal of research indicates that emotion and psychology influence investor decision-making, causing them to respond to market turmoil in unpredictable and/or irrational ways. A lower volatility account in times of broad market swings can help insulate investors from the temptation to make decisions driven by emotion. And a management style sensitive to volatility can be particularly beneficial to investors whose planned-for drawdown times (for example, retirement) occur during a down market. Actively managed accounts also provide investors the ability to speak to a strategist who can provide color and nuance as to the longer term objectives associated with the investment.
A second reason active managers can hope to outperform passive investments over the longer haul is that, with active management, there is at least the opportunity, every once in a while, to take advantage of market anomalies to improve overall performance. It is true that not all active managers know how to take effective advantage of such anomalies; but those who do can make a difference for their clients. And we believe our constant focus on good quality assets can give us this sort of edge. As we enter this tenth year of a bull market in U.S. Large Cap securities, it seems worth noting that when markets are strong, investors are less preoccupied with the quality of the underlying assets. But when markets turn down significantly, quality becomes more important to them. For example, among the many factors we, as managers, consider when researching individual stocks are solid return-on-invested-capital, strong free cash-flow generation, accomplished management teams, visibility of revenue streams and low debt to equity (to name a few), all at a reasonable valuation (some people call this value investing). When we allocate to other funds, we look for managers with a similar bent.
The last nine years or so have, it turns out, generally favored passive managers. After all, if the flagship U.S. Index outpaces most others, and just keeps going up, there is less opportunity for active managers to deploy their “secret weapon” (discernment) to particularly good effect. If history is any guide, after a decade of above-average returns in any asset class, investors will inevitably start looking to other investments, where securities may seem relatively cheaper. (U.S. Large Cap, and especially the “growth” sector represented by QQQ, would seem to be asset classes of this sort today.) They will have to choose whether to invest in individual stocks and actively managed mutual funds or passively managed ETFs and index funds. Those investors should bear in mind that – in international investing, even more than domestic U.S. investing – active managers should have an opportunity to shine. It is nearly an article of faith among those who study markets and investing that, the less efficient the market, the more potential there is for a manager to add value. In the current efficient market, the Large Cap companies are followed intensively by analysts and investors. But even in that sort of market, patient managers (like the folks at Yacktman, for example), have been able to find those sorts of opportunities. And it is almost undisputed that in emerging markets (which have fewer analysts and are the subject of less ubiquitous research), active managers may be able to provide an edge investing in the regions or sectors where there is less information such as Small Cap companies, international stocks and less liquid markets.
As a team, we here at CWC have seen lots of ups and downs in the securities markets (both stocks and bonds). Starting in 1980, the market ran pretty much for 20 years with only one significant disruption (in 1987). The market then suffered through the bursting of the internet bubble, and later, of course, the Great Recession. As we look out at the next three to five years, we are certainly not forecasting another 2001 or 2008, but we do believe market dynamics are likely to shift, and this should favor the well-diversified active investor.
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