August 10, 2010
Conclusions
For advisors looking for proof that active management really works, both of these problems will provide continuing frustration. Ultimately, both relate to the challenge that if and when investment managers can own multiple asset classes – as they are increasingly doing, thanks to the rising popularity of tactical asset allocation investment approaches – it is increasingly difficult to determine what constitutes “the market” and in turn identify what returns are attributable to a manager’s investment policy as opposed to active management decisions about various asset classes.
To our knowledge, there is no publicly-traded “universe” of managers that is sufficiently non-style-constrained. There are, perhaps, a few select managers that engage in such behavior, but in point of fact they do not fit in the general universe of funds; hence, why they are called “eclectic” managers? Perhaps the hedge fund universe is the only one that meets our “active” criteria, and it has problems in terms of survivorship and backfill bias. And either way, as noted earlier, there will be little agreement on what is the proper benchmark to use as a proxy for “market returns” in order to compare hedge funds’ performance to the “market.”
Financial planners who read these latest studies and conclude that 80% of returns are attributable to the market, and that any excess returns over market returns are equally attributable to portfolio policy and active management, should consider the limitations of this study. Insofar as Ibbottson, Xiong, Idzorek, and Chen set out to prove that if you limit your universe to narrowly style constrained managers, you can get insights into the impact of active management amongst that particular peer group of funds, we wholeheartedly agree with them. Nonetheless, as the authors themselves point out, when you consider “eclectic” active fund managers, the results will likely be dramatically different than the average results of those style-constrained managers. If tactical asset allocation is truly an emerging trend of investing, studies like the ones discussed here tell us little about the expected or potential value and relative impact of active management returns on a prospective basis – especially when the active management includes ongoing changes to a fund’s asset allocation.
The original BHB paper has been cited as the most misunderstood and misinterpreted paper in popular finance. Its widely and wrongly accepted conclusion that 93% of portfolio returns are attributable to portfolio policy have been the cause of great mischief over the years as financial planners have interpreted the result to mean that strategic and passive asset allocation has been proven to be the most effective way to manage portfolios.
The Ibbottson paper is a useful addition to the literature on the subject, but financial planners interested in active management should not over-generalize its findings. For eclectic managers who implement management strategies involving actively and tactically changing portfolio asset allocations – which these studies cannot properly measure using their methodology – active management will be a dramatically more powerful determinant of portfolio returns than these studies suggest.
Kenneth R. Solow is the Chief Investment Officer of Pinnacle Advisory Group (www.pinnacleadvisory.com), a private wealth management firm located in Columbia, Maryland, that oversees more than $750 million of client assets. He is also the author of Buy and Hold is Dead (Again), available at www.buyandholdisdeadagain.com. Michael E. Kitces is the Director of Research for Pinnacle Advisory Group, and is the publisher of the e-newsletter The Kitces Report at www.kitces.com.
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