There is no such thing as one superior investment strategy – neither active nor passive. But, this begs the question: how, then, should an investor to choose between them? In short, it depends on your circle of competency. Up now is part three of a four-part dissertation on active vs. passive. In it, I outline a framework for choosing an investment method that is best suited to your needs and abilities. It begins with a brief survey of asset classes, strategies and investment products. And then dispels some of the most common myths and misconceptions of active investing (A PDF version of the entire series may be found here).

I. The Universe of Investments  

Strategies & Asset Classes

All investors are confronted with a choice between active or passive management, on the one hand,[1] and high or low-risk assets, on the other. High-risk assets offer investors the prospect of high investment returns, while low-risk assets promise lower returns. An investor that is willing to venture into high-risk assets may be characterised as aggressive, while an investor that prefers the safety of low-risk assets may be described as defensive. As noted earlier, risk, in this sense, is the likelihood an investor will suffer a permanent loss or impairment of their capital (not the volatility of asset prices). Therefore, a decision to invest in high-risk assets, or to take on more risk, does not guarantee higher returns; it only guarantees the prospect of higher returns. If high returns were a foregone conclusion, then they wouldn’t be riskier. In other words, high-risk assets are those in which the outcome is less certain, but the prospect of both high returns and low returns (and even losses) are more likely. This probabilistic relationship is described as the “risk-adjusted return” on investment and is depicted by something known as the “capital market line” (See Figure 1).[2]

Every investable asset class is characterised by its own unique risk-adjusted return and is represented by a specific point along the capital market line. Asset classes found at the lower end, include cash, term deposits, and other money market instruments, which today yield around 0-2%.[3] Higher risk-adjusted returns are found in fixed income assets, such as short-term government bonds, high-grade corporate bonds, and even longer term sovereign debt, which yield between 3-5%. Further along are large capitalisation public equities, real estate, low investment-grade corporate debt and small capitalisation or emerging market equities, which yield 6-8%. And finally, the highest risk-adjusted returns are found in alternative asset classes, such as private equity and venture capital, which yield anywhere between 8-20%.[4] Both active and passive strategies span across these asset classes, but the difference is that passive investors adjust their preference along the capital market line, while active investors aim to move above the line. In other words, active investors seek to achieve above average returns for a given level of risk, or the same return, while bearing less risk.[5] Such outcomes denote their ability to add value through superior skill, insight, and judgment (or “Alpha”). In contrast, an irrational or unskilled active investor will end up below the capital line. Ultimately, the entire investment landscape may be defined by this choice between active or passive strategies, and high or low risk assets.

Figure 1: The Capital Market Line

Wealth Management Products

The wealth management industry offers a wide range of investment products that cater to every combination of risk appetite and investment strategy. Term deposits, money market funds, broad-based index funds and ETFs are designed for passive strategies, which seek to track the average return of low-risk asset classes. Exotic ETFs, smart-beta funds, and “quant” or technical funds, cater to passive strategies that seek to track the average return of high-risk asset classes.[6] This includes the performance of more speculative “assets”, such as hard commodities and exotic artwork. The defining feature of both product ranges is that they allocate capital according to price rather than value, to achieve average market returns. On the other hand, a range of managed funds, listed investment companies (LICs) and investment trusts cater to active strategies that seek above average returns on low-risk assets (including some equities, bonds and real estate). Whilst hedge funds and limited investment partnerships cater to active strategies that seek above average returns on high-risk and alternative asset classes. The defining feature of both these product ranges is that they allocate capital according to fundamentals, rather than price, and thereby hope to beat the market return.[7] Given this broad selection of investment opportunities, all investors – theoretically – have the ability to achieve stellar returns. So, why don’t they? In other words, why do investors bother with passive management at all, if active strategies always promise to outperform the market?

II. Active Investing is a Zero-Sum Game

The Risk of Underperformance

“There is one important fact about investing and it’s the most important fact that you can never forget…The average performance of all managers before fees has to be the average performance of all assets” – Bruce Greenwald.[8]

Just as taking on greater risk does not guarantee higher returns (only the prospect of higher returns), so too an actively managed fund does not guarantee outperformance, only the prospect of outperformance. If above average returns were a foregone conclusion then they wouldn’t be above average! And, therefore, only those who are willing to suffer the cost of underperforming the market should be willing to risk their capital on beating the market. The key point is that active management is always a zero sum-game (for every investor that outperforms the market, there is another that underperforms the market). As a result, active managers, as a whole, actually underperform the market, after taking their fees into account.[9] In fact, most professional investors perform worse than the average low-cost index fund. Only a small group of talented investors, such as the Super Investors of Graham and Doddsville, consistently outperform the market and even they are usually only identifiable in hindsight. Moreover, their performance tends to decline as assets under management increase. The average or non-professional investor, therefore, usually jumps on board too late and ends up missing the best returns (as the famous adage says: past performance is no indication of future returns). So, unless one has the necessary skill and judgment to identify a quality manager in advance, outsourcing the wealth management process to a professional can be treacherous for your wealth. To use a football analogy, it is akin to a local football hobbyist taking on the role of Collingwood Senior Coach on selection night. Not only are they completely unfamiliar with the team’s experience and ability, but they will be unable to differentiate the incidence of luck and skill in each player’s performance. The inconvenient truth is that the only people who are truly capable of identifying a quality active manager, in advance, are the active managers themselves!

Contrarian or Second Level Thinking

“The problem is that extraordinary performance comes only from correct non-consensus forecasts, but non-consensus forecasts are hard to make, hard to make correctly, and hard to act on” – Howard Marks.[10]

The problem with active management, and the reason it does not guarantee outperformance, is that beating the market return requires contrarian or second level thinking.[11] Many investors falsely believe that being “right” about a company’s prospects is the only prerequisite for superior returns. But if all other market participants are also “right”, then the asset’s price will already reflect its underlying value (and thereby expect to yield the average market return). In order to achieve above average returns an investor must instead identify and then exploit discrepancies between price and value. In other words, superior returns are not a function of buying good assets, but of buying those assets well. Such opportunities will only arise in markets filled with irrational and misinformed investors. But if all active investors believe that they are acting rationally, how is one to find instances in which they are acting irrationally? The only way is to reach an unconventional but more accurate understanding of the economic future. Being contrarian for the sake of being contrarian is not enough (and just as perilous as following the crowd). Instead, an active investor must be able to derive a correct non-consensus forecast from deep and complex insights. Such second level thinking requires a competitive or intellectual edge, the capacity for independent thought, and willingness to ignore the crowd. True contrarian thinking, therefore, is an inherently lonely and difficult task (if everyone could achieve unconventional insights, then they wouldn’t be unconventional). It also makes the active management game a zero-sum endeavour. One in which only a few uniquely talented investors are likely to attain the requisite knowledge, intuition and psychological awareness to achieve above average returns. Such is the nature of active management.

Illusion of the Part-Time Investor

“It’s not supposed to be easy. Anyone who finds [investing] easy is stupid” – Charlie Munger.[12]

Despite these challenges many people still fall victim to the idea that it is relatively easy to outperform the market. Moreover, the notion is encouraged by all manner of do-it-yourself investment books and how-to guides. All you have to do, they say, is a little bit of first-hand research and analysis, filter out the most promising “blue-chip” companies, and then hold them for the long-term. Piece of cake, right? In fact, this seemingly simple path to wealth and prosperity is a complete and utter illusion. As the author painfully discovered in his own early days of investing, working a full-time job and picking stocks in your spare time is like kicking the footy once a week and then playing for Collingwood on the weekend. Not only are you woefully underprepared, but you’re going to get killed out there! Any full-time chef, public servant, or teacher, who is unable to decipher the delicate nuances of a corporate balance sheet, shouldn’t trade mining stocks in their spare time. Investing (like sport) is a professional’s game with professional players. To consistently outperform the market is incredibly hard and requires huge dedication. This is not to say that any ordinary person does not have the capacity to develop the necessary skills and knowledge to achieve stellar returns. They certainly do. The point is that they must first be willing to make that goal a full-time endeavour. Only those who are willing to dedicate the same level of time, energy and professionalism as that of any other full-time fund manager, will be able to compete and ultimately survive the jungle of financial markets. This alludes to the final and most crucial point of this essay: the best method for allocating one’s capital is intrinsically tied to the unique circumstances and ability of every investor.

III. Choosing an Investment Approach    

The Personal Anatomy of Wealth

“There are no solutions, only trade-offs” – Thomas Sowell.[13]

All capital, by definition, is owned and deployed by an individual with certain capabilities and risk preferences. The typical active vs. passive debate ignores this fundamental truth and instead focuses on the relative performance of investment strategies, without the necessary context of the investor. It is akin to your local grocer outlining the relative merits of cooking with tomato puree vs. canned tomatoes, after you expressed an interest in pre-packaged meals! The list of advantages and disadvantages is ultimately irrelevant given your particular needs. In this sense, the most appropriate investment method is not a function of the best performing asset class, highest return strategy, or the most decorated fund manager. Rather, it is a question of whether active or passive strategies align with an investor’s circle of competency. In this sense, the starting consideration for every investor is their unique financial needs, objectives and understanding of the investment process. This is, arguably, the most crucial element of investing. Without a clear grasp of one’s capabilities or goals, any foray into the world of capital allocation is fraught with danger (for there is no quicker way to part with one’s capital than to invest it in products you do not understand or are ill suited to your particular needs). Such preferences are deeply intertwined with one’s personal situation, income capacity, expenses, timeframe, skills, and knowledge. As such, we believe that there are two key questions for every investor to consider. Firstly, are they willing to pay a premium or budget price for accessing investment returns? And secondly, are they more interested in relative or absolute performance? Only then may an investor select the most appropriate investment strategy (active or passive) and asset classes (high or low risk).

An absolute performance benchmark is a a targeted rate of return, which is independent of the market environment. In contrast, relative performance benchmarks are derived from the average market return. An investor’s preference for absolute or relative returns is dependent on their understanding of the capital allocation process and tacit economic knowledge. Individuals with unique insight and superior skill will prefer an absolute return, as they seek to profit from their accrued wisdom. Alternatively, an investor with no apparent skill or insight will desire a relative performance benchmark, as their lack of understanding creates the need for protection from loss or underperformance, rather than opportunity to generate above average returns.[14] The second consideration for every investor is their willingness to incur cost or fees in the pursuit of returns. This choice is often defined by an investor’s tastes or economic circumstances. An investor with the economic capacity to incur higher fees, or a desire to outsource the investment process, will prefer a professional or premium wealth management service. Alternatively, an investor who is unable to incur such cost, or is willing to exercise some responsibility over the wealth management process, will opt for a budget-conscious solution. Such considerations are analogous to the trade-offs confronted by any ordinary consumer in their everyday purchasing decisions. For example, consider the man who is willing to substitute a more expensive but premium quality steak from his local butcher, for a cheaper but lower quality alternative at a nearby supermarket. Neither steak is necessarily better than the other; they just satisfy a different type of need or value to the consumer. Ultimately, all investors may be defined by their desire for high or low cost access to returns, and absolute or relative performance.

Investor Types According to Need

This leaves us with four categories of investor: the average retail investor; the institutional investor; the high net-worth individual and the entrepreneur. The average retail investor may be described as relatively uninformed and with limited knowledge of the capital allocation process. They are budget conscious and in need of an investment method that will not only protect them from what they do not know, but also provision for their retirement. In other words, they value low-cost access to returns and a relative performance benchmark. Despite our innate propensity for over-confidence, most people fall into this category.[15] Institutional investors also lack any discernible economic insights from which they may derive a profit, but usually hold a broader understanding of the investment process and are beholden to a relative performance benchmark (either by charter or law). Given their size and economic resources, institutional investors are willing to pay higher fees for the sake of a professional service. In contrast, high net-worth individuals are usually endowed with specialist economic knowledge or expertise, which they have accrued in the process of building such wealth. Accordingly, they are either capable of identifying a quality active manager, or are willing to bear the extra cost of a professional service. Finally, the entrepreneurial investor seeks to profit from their tacit knowledge and create a self-sustained economic existence. They hold deep technical expertise or understanding of a certain trade or industry. Accordingly, they seek low-cost access to absolute returns and are uninterested in bearing the high cost of a professional fund manager. Rather than wealth accumulation, they seek long-term wealth creation. The final question, then, is what strategies, asset classes and products are most aligned with each investor’s needs and competencies?

When to Be Active or Passive

“If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence” – Charlie Munger.[16]

The average retail investor is ideally suited to a passive management approach. This means adopting a selection of broad-based index funds and ETFs, which offer the lowest cost access to average market returns. By holding an extremely diversified portfolio of liquid public assets, such products protect the average investor from individual corporate failures, as well as individual corporate gains. In other words, they allow an uninformed person to avoid underperforming the market, as well as outperforming it. The retail investor benefits from the rational effort of other investors to ensure asset prices – and returns – do not stray too far from the long run productivity of capital. Such average performance is perfectly aligned with the retail investor’s need for long-term wealth preservation, rather than accumulation.[17] However, the approach is not completely divorced of any conscious decision-making. An inherent by-product of rock-bottom management fees is that the retail investor must still exercise some discretion over the selection of assets (also known as tactical asset allocation). As highlighted earlier, every investor is presented with a choice between high and low risk asset classes. The most appropriate selection of cash, bonds, equities, or real estate will ultimately depend on the investment time frame and income requirements of each investor.

Institutional investors are also ideally suited to a passive management approach i.e. a professionally managed product that utilises a diversified portfolio of assets to outperform a relative return benchmark. Such managers generate above average returns through superior indexing methods, weighting of asset classes or hedging techniques. They both benefit from, and incur the cost of, rational effort by other investors to ensure that prices tend toward value.[18] This premium service usually incurs high management and performance fees. Institutional investors are, therefore, at risk of both underperforming the market and outperforming it (once fees are taken into account) and must exercise a degree of second level thinking. The reality, however, is that most institutional investors are usually incapable of telling whether a particular asset manager is endowed with the skills, talent or process to consistently beat the market.[19] In contrast, high net-worth individuals are ideally suited to an active and collaborative investment approach. Namely, the retention of alternative asset managers through a limited partnership structure. High net-worth investors are able to identify a quality investment manager by virtue of their accrued economic knowledge and competency. Chosen managers then seek to exploit discrepancies between price and value through special situations and direct asset intervention.[20] The concentrated and illiquid nature of their portfolio, as well as the labour-intensive process, is what leads to uncorrelated returns and the highest professional fees. Nonetheless, this approach satisfies both the investor’s desire to outsource the wealth management process and profit from their accrued knowledge.

Finally, entrepreneurs are (obviously) suited to being the founder or majority shareholder of a proprietary limited company. Rather than profit from inefficient markets, they seek to create wealth by building or entering entirely new markets. More specifically, they work to devise new technologies, business models and organisations that may satisfy a variety of unmet customer needs. For their ingenuity, entrepreneurs are rewarded with the prospect of abnormal and absolute returns.[21] Such wealth is a by-product of their concentrated ownership and close proximity to the business process. This approach satisfies both the desire for low cost access to returns and economic independence. However, the method also comes with significant risk, such as bankruptcy, and few people usually have the requisite skills, knowledge and resourcefulness to succeed. Entrepreneurship requires an ability to view the world in unconventional ways, or to “see what everyone else can see, but then think what no one else has ever said”.[22] These investors are not speculators or gamblers, but innovators. And in this sense, they are the ultimate value investors! In conclusion, each type of investor is compelled to exercise some form of responsibility or judgment over the wealth management process (albeit minor in some cases). The most important thing is for such decisions to be strictly confined to an investor’s defined circle of competency, in order to reduce the likelihood of permanent loss or impairment of capital (See Table 1).

Table 1: Comparative Investment Methods
Average Retail Investor Institutional Investor High Net-Worth Individual Entrepreneur / Founder
ETFs, Index Funds Managed Funds Investment Partnerships Proprietary Limited Company
Vanguard, Black Rock AQR, Bridgewater Oaktree, Founders Fund Apple, Microsoft
Self-Directed / Low-Cost Premium Service Premium Service Self-Directed / Low-Cost
Passive (Momentum) Passive (Momentum) Active (Value) Active (Value)
Defensive Aggressive or Defensive Aggressive or Defensive Very Aggressive
Wealth Preservation Wealth Management Wealth Accumulation Wealth Creation
Average Risk-Adjusted Return Above / Below Average Returns Uncorrelated Returns Abnormal Returns / Bankruptcy
Management Fee Relative Performance Fee Absolute Performance Fee Cost of Capital
Silent Shareholder Minor Shareholder Major Shareholder Majority Shareholder
Agnostic Rational / Irrational Rational / Irrational Genius / Insane
Quantitatively Driven Quantitative & Qualitative Quantitative & Qualitative Qualitatively Driven
Algorithmic Trading Investment Team Collaborative Investors Hierarchical Organisation
Long Term Medium to Long Term Medium to Long Term Long Term
Tactical Asset Allocation Irrational Behaviour Special Situations Innovation
Productivity of Capital Under or Overvalued Securities Catalysts for Change Customer Satisfaction
Tracks Value Uncovers / Captures Value Unlocks / Builds Value Creates Value
Very Liquid Holdings Liquid Holdings Illiquid Holdings Very Illiquid Holdings
Extreme Diversification Diversified Portfolio Concentrated Portfolio Extreme Concentration
Market Entry & Exit Risk Systemic Tail Risk Liquidity Risk Business & Industry Risk
Bears Incremental Risk Manages Risk Controls Risk Owns Risk
Dollar-Cost Average Margin of Safety, Hedging Board Authority Management Authority
Public Assets Public & Alternative Assets Alternative Assets Private Assets
Efficient Markets Efficient & Inefficient Markets Inefficient Markets Builds / Enters New Markets

 


[1] As outlined in Part I: A Dynamic Theory of Financial Markets, active strategies seek to exploit inefficient markets, or discrepancies between price and value, to generate above average returns, while passive strategies, seek to track efficient markets, or the tendency for prices to converge on value, to achieve the average return.

[2] The greater uncertainty or distribution of outcomes, which are associated with higher risk assets, is denoted by the ever-widening bell curve. Note that the inclusion of this bell-curve may be attributed to the handiwork and insight of Howard Marks, See: The Most Important Thing Illuminated, Columbia Business School, 2013 pg. 42. 

[3] Burton G. Malkiel, A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, Norton, 2016, pg. 308-309 (All expected yield figures are derived from the latest edition).

[4] Note that current expected returns across all asset classes are below their long term historical average, as a result of central bank efforts to reduce the cost of capital across all financial markets (i.e. the capital market line has been pushed downward). 

[5] See supra note 2, pg. 74.

[6] “Smart-beta” refers to the use of alternative index construction rules to that of traditional market capitalization based indices.

[7] The reader should note that this catalogue is not intended to be an exhaustive summary of potential products. Furthermore, the segmentation of asset classes and vehicles is not a binary phenomenon. Some securities, such as corporate equities, may fall within any subset of products.  

[8] Bruce Greenwald interview with the Motely Fool, October 20, 2013, available at: https://www.youtube.com/watch?v=vVdBATXxbBg

[9] See supra note 3.

[10] Supra note 2, pg. 6.

[11] Ibid. Chapter 1.

[12] See supra note 2, pg. 1.

[13] Thomas Sowell, A Conflict of Visions: Ideological Origins of Political Struggles, William Morrow & Co. 1987

[14] An investor that seeks to be fully invested, at all times, as well as maintain a certain degree of purchasing power, will also prefer a relative rather than absolute performance benchmark. See: Seth Klarman, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor. 1991. New York: Harper Collins Publishers.

[15] This is not to say that there is something unseemly about this type of investor. It simply denotes the fact that not everyone can be above average and that most people prefer to spend their time pursuing other professional endeavours.

[16] Charles Munger, Speech to USC Business School entitled: A Lesson on Elementary, Worldly Wisdom as It Relates to Investment Management & Business, 1994. Available at: http://old.ycombinator.com/munger.html

[17] Note that capital allocation decisions by the average retail investor are represented by movements along the momentum curve in Figure 1 of Part I: A Dynamic Theory of Financial Markets.

[18] Institutional investor efforts are depicted by movements along either the value or momentum curves in Figure 1 of Part I: A Dynamic Theory of Financial Markets.

[19] As long as certain entities remain legislatively entrusted to serve as permanent intermediaries in the investment process (such as industry super funds or sovereign wealth funds), so too will this misallocation of resources prevail.

[20] High net-worth investor efforts are depicted by movements along the value curve in Figure 1 of Part I: A Dynamic Theory of Financial Markets.

[21] Entrepreneurial investment endeavours are represented by movements of the value curve, as depicted by Figure 1 of Part I: A Dynamic Theory of Financial Markets.

[22] Quote attributed to Amos Tversky, See: Michael Lewis, The Undoing Project, W.W. Norton, 2016.