Active Portfolio Management

Is it possible to outperform the market? This is one of the most important questions any investor should ask. If your answer is no, if you believe the market is efficient, then passive investing or indexing buying diversified portfolios of all the securities in an asset class is probably the way to go. The arguments for such an approach include reduced costs, tax efficiency and the fact that, historically, passive funds have outperformed the majority of active funds ).

But if your answer is yes, it is possible to beat the market, then you should pursue active portfolio management. Among the arguments for this approach are the possibility that there are a variety of anomalies in securities markets that can be exploited to outperform passive investments, the likelihood that some companies can be pressured by investors to improve their performance , and the fact that many investors and managers have outperformed passive investing for long periods of time.

But the active investor must still face the challenge of outperforming a passive strategy. Essentially, there are two sets of decisions. The first is asset allocation, where you carve up your portfolio into different proportions of equities, bonds and other instruments. These decisions, often referred to as market timing as investors try to reallocate between equities and bonds in response to their expectations of better relative returns in the two markets, tend to require macro forecasts of broad-based market movements. Then there is security selection picking particular stocks or bonds. These decisions require micro forecasts of individual securities underpriced by the market and hence offering the opportunity for better than average returns.

Active investing involves being overweight in securities and sectors that you believe to be undervalued and underweight in assets you believe to be overvalued. Buying a stock, for example, is effectively an active investment that can be measured against the performance of the overall market. Compared with passive investing in a stock index, buying an individual stock combines an asset allocation to stocks and an active investment in that stock in the belief that it will outperform the stock index.

In both market timing and security selection decisions, investors may use either technical or fundamental analysis (. And you can be right in your asset allocation and wrong in your active security selection and vice versa. It is still possible that an investor who makes a mistake in asset allocation, perhaps by being light in equities in a bull market, can still do well by picking a few great stocks.

There are arguments for both active and passive investing though it is probably the case that a larger percentage of institutional investors invest passively than do individual investors. Of course, the active versus passive decision does not have to be a strictly either/or choice. One common investment strategy is to invest passively in markets you consider to be efficient and actively in markets you consider less efficient. Investors can also combine the two by investing part of a portfolio passively and another part actively.

The right venue, the right style

It is an old adage of investment cynics that "managers do not pick markets, markets pick managers." This attitude suggests that brilliance is about evenly distributed, but that markets select their own heroes rather than vice versa.

With the construction of investment styles according to the radiation approaches I have described, that limitation is not quite true. Rather, managers can freely roam the world looking for an investment style that suits them a growth manager could have a period of successful investing in the United States, become a non-US manager, and then find a suitable venue in emerging markets: three investment lives all engaged in approximately the same principle. One can invest in all traditional ways and change location, or one can change investment techniques and invest in the same location.

How did you know a growth company in the 1945 and later period? I knew it when I saw it. When I see it again, now, in an emerging market, I say, "this company can compete on a world-wide basis, regardless of the fact that it is ... wherever."

The US style is now flexible, fast and fuzzy. The developed (ex-US) market style is structured, systematic and suited to individual customization. And despite the global economic crisis, emerging markets are the places where there is the greatest potential for growth if we hark back to the high-quality investment styles of yore.

Market students must look geographically outwards to see familiar, repeated patterns and inwards to see what is next.

Investing in US in 1970-1990

The post-World War II era and its corollary in other markets of the world ended after a generation, almost simultaneously, with academic studies on efficient markets achieving prominence in the United States. Firms capitalized on this phase shift by introducing index products and popularizing valuation shifts and new valuation techniques that are all price-related. As the dictum shifted to "buy low, sell high," it was characterized by the emergence of new investment folk heroes like Warren Buffett. A few firms, Batterymarch among them, popularized valuation techniques for institutional investors, giving voice to this newly emerged market style in the United States.

In Europe and Asia, internationally dominant companies, which looked very much like the nifty fifty, appeared popular for investing. Siemens, Hitachi, Sony, Philips, Bayer and their counterparts became components of more venturesome US institutional portfolios and appeared as the first equity holdings of some of the more fixed-income-oriented institutional holdings outside the United States.

And exactly the same pattern seen in the United States during 194570 was repeated, except in different places, in different markets.

Development institutions then shifted their attention from the devastated areas of World War II to the poorer countries suffering from population explosion. In many cases, these were agrarian-based economies with little ability to soften the shocks and cycles inherent in farming. These markets that had previously been worrying about subsistence began to establish the basis for market economies. Largely influenced by government programs, some of these countries began developing market structures.

Investing after WW2

Right after World War II, a widely anticipated global depression was expected a common occurrence after nearly every major world conflict. Surprisingly, in the United States, a major interest in equities prompted the success of a handful of companies that became known as the nifty fifty. These companies dominated in managerial skills, product R&D and financial resources. Investors remained skeptical about economic progress throughout this growth era, and markets faced the traditional wall of doubt, the trellis up which green investment ivy must climb.

''Buy high, sell higher" dominated investment styles over this period. Supply and demand for equities became the watchword more than underlying valuation. To adapt a phrase from a quantum physicist, "there appeared to be an underlying price spin tilted in the direction of the positive" other things being equal, something that had gone up would go up more. Another description might be the economics of increasing returns. Eventually, the era ended with the shock of 1967 and the subsequent decline of growth funds in the sharp market downturn in the United States during the 19734 period.

The developed (ex-US) markets essentially those of the advanced countries that were the major protagonists in World War II, whether victor or vanquished during this period were dominated by international reconstruction programs. The Marshall Plan in Europe and its counterpart under the administration of General MacArthur in Japan and Asia led the way. These programs were typically centered around infrastructure improvement and, with the exception of the UK, did not produce much in the way of private equity development until the second half of the period, when government programs became directly supportive of private development activities.

Style radiation

The spread of investment insights may be visualized as waves radiating outwards in concentric circles from pebbles falling into water. The source of these investment pebbles is the United States. The dynamic force behind the rise of post-World War II equity markets has been academic research coming out of US universities. The availability of cheap computer time, cheap graduate student labor and creative senior professors (six of whom have now received the Nobel Prize in Economics) has contributed to the development of concepts like the capital asset pricing model, the efficient market hypothesis and performance measurement, as well as the growth of derivatives markets.

Not every investment technique is appropriate at every place around the world at the same time. Ideas radiate, interfere with one another and produce new patterns, then reach the periphery at the same time as new stimuli occur at the origin. Technology and communications accelerate the speed of ideas radiating outwards until, finally, the impact reaches emerging markets. As the process is repeated, it is accelerated further.

We can divide the investment world into three parts the United States, developed (ex-US) markets and emerging markets. Most US institutional investors have dedicated teams covering each of these segments. In some cases, they have specialized teams within each team segmented by geography.

The investment world was reshaped immediately after World War II. In fact, if we go back farther, we can gauge the present long-wave bull market from the Battle of Midway in 1942. If we look at equity styles since then, we see that there have been two
major waves, each lasting one or two decades. And a third may have begun.

Paying down debt: the delicate dilemma

As we close our discussion of debt, we must address one of the more delicate dilemmas of modern marriage: how to handle debts each of you may have accumulated before the nuptials. Years ago, such a discussion hardly would have been necessary. People married young, well before they had accumulated significant debts—or assets, for that matter. Today, the opposite is often true. When people wed today, it may be after a decade or longer as professionals, plenty of time to borrow plenty of money. The same is true of people in second or third marriages. It would be hard to imagine people in that situation without some debt burden. When couples bring individual assets to the marital table, that’s a cause for joy. When the baggage includes debts, the issue is more complex and more volatile. Broadly, there are two approaches you can take to premarital debt. You may decide to reduce your debt as individuals, or you may elect to pay down premarital debt as a couple. Each approach brings advantages and disadvantages. Paying down premarital debt as individuals can prevent conflict, particularly if one party incurred substantially more debt than the other. With this approach, the partner with the smaller debt load doesn’t feel financially strapped by decisions made before the marriage. This approach also permits each spouse to maintain a significant level of independence. But there are disadvantages as well. For one, the debt might not be paid down as quickly or as efficiently as possible, because only one partner is focusing on it. In addition, that partner may feel resentment at being abandoned on Debt Island. That could promote continued use of debt, resulting in financial hardships and marital discord.
If you elect to pay down premarital debt as a couple, you can develop an efficient game plan that emphasizes quick payment of high-interest debt. You can get out of debt more quickly and focus on your goals as a couple. This joint process also implies regular communication about debt, an activity that will help you many times over.
The principal disadvantage to this approach is that the partner who kept the slate relatively debt-free may feel exploited; the good spending habits he or she developed might appear to have come to naught.
As we mentioned, this is a sensitive matter, and we don’t recommend one approach over the other. What we do recommend is talking about any premarital debt and developing a game plan that pays off all debts quickly while keeping both partners satisfied with the strategy.

Comfort Zone Investing Case Study

Michael and Susan have been saving for retirement for 10 years. They are a composite from interviews and people I have worked with during the past 21 years. Since Michael’s major promotion 10 years ago, they have invested about $50,000 a year. Prior to that, they had less than $10,000 in investments. Now, stockbrokers, realtors, insurance salespeople, venture capitalists, hedge fund vendors, and other investment product peddlers have their number and routinely call them. Michael and Susan have compiled investments worth $450,000 during the past 10 years: half in a 401(k) and half in an online brokerage account. Immediately, you might notice the math. If they have invested $50,000 a year for the past 10 years, achieving a zero total return on their money, they should have $500,000 in investments. You might do the math, but Michael and Susan have not. You would also think that Michael and Susan would be happy with the size of their nest egg. Sill in their mid-40s, they are in the top 1 percent of wealth in the world. But they are miserable. Michael losses sleep over his investments regularly. Though he works 60 hours a week, he finds time several months a year to shift between $100,000 and $300,000 from one investment fad to another, believing he will increase his returns and then be happier with his portfolio. Among the other high-income employees where he works, this is routine practice. In fact, the main non-work-related topic among these employees is investing. Though not one of them has ever calculated their annual returns, they all constantly chase high returns and lose sleep worrying about the market. Susan, a stay-at-home mom and part-time consultant, is equally unhappy with their investments. She wants Michael to work less, even take early retirement, and consult part-time so he does not miss his children’s childhood years. She is certain they were happier before Michael’s big promotion. She is angry that their portfolio is in constant flux. She has no understanding of why one year they seem to have all their money in small cap stocks, the next year in municipal bonds, then in tech stocks, and now in hedge funds. She is convinced that they are on the verge of losing it all any minute and she will have to go to work full-time. You might think the case of Michael and Susan is unusual. It is not. Studies by Dalbar Inc. and others show that as many as 90 percent of individual investors underperform stock market averages because they buy and sell too often. In fact, studies by Brad M. Barber, Terrance Odean, Moringstar, and others have shown that individual investors make returns about half as high as the stock market. During 1970-2000 period when the market made 12 percent a year, individual investors made 6 percent. Individuals even underperformed the bond market by a significant margin. However, hiring professional money management does not solve the problem. Studies by Mark Hulbert and others show that professional money managers also trade too often and underperform the stock market 80 percent of the time. Unfortunately, all these studies focus on investment return.