In reading Garrett Baldwin’s interview with Thomas Howard, I had a “Duh” moment. When discussing Howard’s research I was initially skeptical but interested in reading new evidence of the value of active investing. However, the idea that active managers actually did add value, but costs and other factors made passive index funds a better bargain for investors, was a disappointment. Of course, these people were better at picking stock than a monkey throwing darts—an oft-repeated anecdote of the passive investing fan club. But the fact that these managers had skill, but perhaps could not overcome fees structures and other headwinds, seemed to me irrelevant.
If, in the end, your performance was worse, it was worse.
That is why, especially in the alternative space, performance is reported net of fees. What you produced was the bottom line. If, net of fees, you outperformed the competition, what does it matter what your fees were, you obviously earned them.
So when I saw Howard’s argument that active managers are consistantly good, better then the indexes, except that they got so big that it degraded their performance, I was a bit flabbergasted.
I have profiled literally hundreds of managers and a basic question I would always ask—mainly of commodity trading advisors—is what is your capacity? Meaning, how much money can you manage and when must you stop taking new money to avoid having your performance degrade? Typically, I would get two answers: One was the figure they had in mind of ultimately how much money they could safely manage without it affecting their performance, and next was a smaller number (perhaps half of the larger number) where they would freeze new allocations to see how it affected performance and to explore if they would have to alter their trade entry models to avoid slippage.
In “All about risk,” (page 60) Kathryn Kaminski discusses risk management. The piece came from a white paper she wrote for CTA Campbell & Co. One of the four major risk factors cited was capacity. It attempted to measure the risk of reallocating capital in the face of capacity constraints. It is interesting coming from Campbell because more than a decade ago Campbell, following a tremendously strong performance streak, decided to increase the minimum investment level for its public commodity pool. The firm had increased the minimum from $10,000 to $100,000. They purposely were seeking to slow the amount of investment to ensure that their existing customers were not harmed from the increased size of the fund.
To me, viewing it from the alternative space, this has been a no-brainer. At some point—and it is true at different levels for every strategy—you reach a level of assets under managemnet where you will no longer be able to produce the same results. At that point,
the prudent thing is to stop taking allocations.
One of the most successful managers I had profiled froze their CTA program at $100 million. They could have gotten to $500 million or $1 billion with a stroke of a pen but felt they could not guarantee such an increase in assets would not change their performance so they didn’t take more assets.
So, to argue active managers would outperform passive investments if they just weren’t so greedy is a non-starter. Perhaps regulations need to change to allow for the futures model that charges an incentive fee. Dunn Capital Management charges no management fee. While mutual funds tend to have lower overall fees, the idea would be to extract fees through performance, not the amount of assets you attract. When fees are charged based on the amount of assets you raise, a manager’s incentive is to collect and maintain assets more than to produce alpha.
Active managers have the right to charge whatever fees they wish, but this is a bottom-line business and the bottom line is what you ultimately produce.
I approach this from the futures/alternatives side, never being an expert in equities. What I liked about futures is that you made a call: Up or down. And I liked the fact that alternatives mainly are absolute return. Making money is good, losing money is bad. While there are better or worse environments, there is no built-in excuse: “We lost 15% on the year but the S&Ps were down 20% so we are all-stars.” That is what is attractive with indexing. There is a number you are expected to get from the market and if you beat it, you did well. However, the market will have good years and bad years and you need an investment with no excuses. An investment that you would expect to do well when the overall stock market and the economy as a whole do poorly.