Unconventional Wisdom: Uniting Active and Passive Management

“Dow plunges over 300 points, leading to global market rout.”

“Bears prowl Wall Street; Global investors flee from equities.”

“Investment banks on the brink of collapse.”

Headlines like these are unnerving, to say the least. And after nearly a year of such reports, it’s common, and entirely normal, to feel intense pressure to do something... anything!... to relieve the pressure.  But resisting that instinct is key to generating solid long-term performance.   Too many people give up too much long-run return in a (mostly futile) effort to avoid short-term volatility.  As long as you believe, as we certainly do, that world-wide economic fundamentals will produce long-run value and that this value will be reflected in world equity markets, then you will participate in that appreciation and this bear market will eventually become a distant memory. Of course, the market may (or may not) decline further over the next several weeks and months, but for the committed long-term investor, these interim bumps in the road are of relatively little long-term consequence... and trying to avoid them is itself very risky indeed.

This logic is familiar to long-tenured clients, but even those accustomed to riding out the global equity markets’ swings sometimes look at their portfolio and ask, “Shouldn’t we be doing something?” Consequently, we think that the current difficult investment environment offers a good opportunity to remind clients of key elements of our investment approach. That strategy combines the best aspects of both “active” and “passive” management to create investment portfolios that:

• are low-cost,
• tax-efficient,
• reflect markets’ general efficiency, and
• capitalize on broad changes in the capital markets and their narrow, but durable, inefficiencies.

Investing against the tide

While we consider our clients’ portfolios to be actively-managed, it is not what most people consider “active management”… i.e., the process of identifying managers who, due to superior skill and insight, are likely to outperform a given index and other similar managers. Although we recognize this common definition of active management, we don’t apply it to client portfolios since there are several serious problems with this approach:

Active risk. Investors earn returns by participating in economic activity and bearing risk as a result. The equity markets, in the aggregate, provide long term investors with a handsome return for just “showing up” and intelligently putting their capital at the risk of short-term loss. This risk is called “market risk.” If investors want to earn returns beyond what the market provides, in this sense, “free”, it requires taking additional risk, for example, by selecting some subset of securities or even an individual security that one believes is incorrectly priced and, therefore, will outperform the broader markets. This divergence from the market creates “active risk,” the risk that an investor will get it right and do much better than the benchmark…or get it wrong and suffer performance significantly less.

If an investor has a finite “risk budget,” (the total quantum of risk, of whatever kind, that the investor is willing to bear to pursue desired returns) then the more of that total budget spent on active risk, the less the investor has to spend on market risk. Looked at in the other direction, the less active risk we take, the more total risk we have to allocate to high expected return asset classes (more on this below).

Cost. The large majority of most active managers’ returns are determined by the market, with active risk hopefully providing a little “alpha” above what the market provides for free. Unfortunately, investors typically pay a great deal for that alpha, as active management is generally characterized by high tax exposure, transaction costs, and management fees, which combine to create a substantial headwind that could otherwise be avoided by using a lower-cost approach.

Skill dilution. Managers who do have demonstrative skill frequently dilute it by allowing assets to balloon, leveraging their fame to open new funds, and shifting their focus from portfolio management to marketing and managing large teams of analysts.

Lack of persistence. Some active managers will beat their benchmark in any given year; this must be the case since the benchmark is simply an average with some above and some below. But, it is so difficult to identify those winners beforehand that no one has shown the ability to consistently do it. Moreover, numerous studies have shown that excess active returns do not persist, and that the only accurate predictor of good future performance is the fee level (i.e., the lower the fees, the more likely the manager or fund is to perform well).

Believing markets work

Aspiriant believes that markets do work and are inherently (and, with globalization, increasingly) efficient; consequently, if an active manager, operating in the public markets (more on private markets below), manages to beat the market, it is likely to be by a small amount and for a short period of time... most of the time, any excess return over the market will be consumed by transaction costs, fees and taxes. Indeed, if you look at the aggregate performance of US equity managers, their mean pre-tax performance is about equal to that of the market, less the average of their management fees (and after-tax performance is even worse!). Logically, this must be the case because, collectively, they make up practically the entire market and so, on average, they cannot beat it.

Investors can always get higher expected investment returns by intelligently accepting more market risk – one doesn’t need “active management” for that. An investor could increase allocation to equities or even borrow on margin to augment an investment portfolio. Our strategy is to reduce active risk in investment portfolios, allowing clients to deliberately take on more market risk, increasing the total return of the portfolio without increasing the total risk.

For example, if an investor hires an active manager to beat the S&P 500 index, a reasonable goal would be for the manager to outperform the index by 1-2% after fees. In fact, very few active managers have been able to do that over time. Aspiriant’s approach, in contrast, is to use a low-cost, tax-efficient manager to replicate the S&P 500, but increase the portfolio’s allocation to, say, emerging markets, which we expect to average about 2% more than the S&P 500 per year. We have a much higher degree of confidence that emerging markets (or small cap or value stocks for that matter) as a whole will significantly outperform the S&P 500 over time than the ability of any particular manager to durably outperform that index. (The chart below illustrates these opposing approaches.)

Rather than investing with the headwind of taxes, fees, and market efficiency in our face, Aspiriant puts the efficiency of public equity markets to work for clients by implementing portfolios using a highly diversified, low-cost, tax-efficient, passive approach that systematically targets three key risk factors that drive returns --- exposure to the equity markets (vs. bonds), the size of companies you invest in (the “size effect”), and the relative valuation of companies (the “value effect”). Over a century of data on investment returns shows that these three factors drive investment returns in public equity markets – not revenue growth rate, or market share, or a host of other factors that occupy most investors’ focus.

Active “passive management”

By designing portfolios of public equities that focus on inexpensively and efficiently capturing these three dimensions of public equity returns, we can focus our attention on adding value… above what the market provides for free… through truly value-added, but unconventional forms of “active” management. We actively manage clients’ portfolios in five key ways:

Asset allocation. Research indicates that asset allocation accounts for nearly all of the difference in returns between any two portfolios, with all other factors (e.g., active trading, market timing) adding negligible value. Consequently, we focus much of our effort on developing portfolios that include substantial allocations to high-growth areas of the global market, including emerging markets and overseas small company stocks. Freed of the active risk that comes with active managers, Aspiriant tilts clients’ portfolios toward these higher-return asset classes while staying within clients’ total risk budgets.

Shifts in investment strategy are expensive, often triggering large tax liabilities, so we generally change clients’ portfolio strategy only as our capital market expectations change or as new asset classes become more readily accessible. These changes are usually incremental “tweaks” but, over time, reflect the changing dynamics of the global investment markets.

A recent example of how changing capital markets impacts clients’ portfolios is global public real estate. The commercial real estate markets in developed economies worldwide look much like the US real estate market 30 years ago, before widespread use of the real estate investment trust (REIT). As late as the early 1980s, most US commercial real estate was closely held by individuals and small partnerships; consequently, many real estate assets were inefficiently managed because they were not subject to the competitive forces of the markets. REITs facilitated the efficient public ownership of real estate, which unlocked an immense amount of value. We expect a similar dynamic to play out in developed economies worldwide as commercial real estate, currently mostly privately-held and not put to its highest and best use, is transitioned to public ownership. As a result, we will continue to look for opportunities to invest in real estate outside the US.

Public vs. private investment. While we believe in the efficiency of the public capital markets, and are impressed with the talent at public companies, public markets do not capture all profitable investment activity. Profitable activity occurs in private markets for many reasons – a company’s investment timeframe may be incompatible with the public market mindset, onerous regulations may discourage risk-taking by public companies (thus encouraging re-privatization or never going public in the first place), or local capital markets may be undeveloped.

In an effort to capitalize on the activity in these comparatively inefficient markets, where information and capital flow much more slowly than in public markets, Aspiriant clients have to gain exposure through active managers, partly because few passive options exist, but more importantly because many managers in these markets, unlike those operating in the public markets, have demonstrated the ability to consistently generate attractive risk-adjusted returns that justify their fees, liquidity restrictions and lack of transparency. This can result from the manager having a significant information advantage in a highly-specialized niche or being able to significantly influence the drivers of the investment outcome… capabilities that few public equity managers can claim.

For example, many Aspiriant clients invest capital with a manager that has reliably generated compound annual returns in the high-teens by exploiting pricing inefficiencies in Central European closed-end mutual funds, among other exotic markets. Real estate managers with specialties as varied as middle-class housing in Brazil or rent controlled apartments in New York have generated returns in the high-teens over time. And returns in the low 20 percent range have not been uncommon for top-tier managers in private equity markets… those with a manageable asset base and, typically, a clear focus on an underappreciated part of the global economy.

Financial innovation. The financial markets are constantly evolving, and it is important that our implementation of client portfolios keeps up with the state of the art. Several times over the last few years we have changed managers to take advantage of lower-cost, more tax-efficient alternatives. When we have seen attractive opportunities to enhance clients’ returns or reduce costs with an entirely new vehicle, we have, on several occasions, promptly adopted that new vehicle or even facilitated its creation to benefit our clients.

A recent example is our close collaboration with Goldman Sachs in 2007 to create the “GS Connect S&P GSCI Enhanced Commodities Trust” more commonly known by its ticker symbol GSC. This fund solves a number of the structural deficiencies associated with the standard commodities index funds, resulting in materially higher expected returns, at much lower tax cost, all without losing the desirable low correlation benefits of commodities. You can read more about GSC in an article we wrote in our Q2, 2007 Commentary, and about financial innovation more generally in an article from our Q3, 2007 Commentary. This month, we will introduce two new fixed income solutions -- a commingled access vehicle and an expanded line-up of public vehicles -- intended to broaden clients’ exposure to fixed income markets and take advantage of the continuing market dislocations.

Rebalancing. Once clients establish a target allocation, Aspiriant actively manages the portfolio to make sure that it stays consistent with client objectives, and within a pre-defined range around the target. Recent research indicates that disciplined rebalancing (i.e., selling high and buying low) can add 0.5% or more to returns annually. Aspiriant has been an industry leader in developing this research, and is among a handful of firms to have recently pioneered new software that enables us to efficiently rebalance portfolios more frequently.

While rebalancing activity is always important, it’s particularly crucial in volatile markets, when there’s likely to be a wide divergence in performance between the asset classes. Recently, for example, we have even pared back clients’ already relatively small allocations to commodities, which have appreciated over 42% this year. A rebound in equities might well be accompanied by (indeed, might be caused by) a steep decline in energy and other commodity prices; consequently, maintaining discipline and focus on the well thought out long-term plan is critical to achieving investment success over time.

Tax management. As recent quarters have made you well aware, equity markets are inherently volatile and, while that can be painful at times, it presents us with a great opportunity to stockpile capital losses for use to offset future capital gains, all while ensuring that the portfolio is fully exposed to the equity markets. For newer clients, or those who have recently added to their portfolios, the recent market downdrafts can be particularly unnerving. However, if one expects, say, a 9% or 10% annualized portfolio return over one’s entire investment timeframe then it’s actually far better to experience negative returns early on in the timeframe. This might seem counter-intuitive and flies in the face of much conventional wisdom. But, if the end financial result at the culmination of the investment time frame would be the same, it is better to have losses (to capture for tax purposes) early to improve overall after-tax portfolio returns. In the diagram below, path 3 from the value of A to the value of B produces a better after-tax result than either path 1 or path 2, both of which would feel better to most investors.

Having said all of this, no amount of logic can completely offset the visceral reaction one feels when experiencing the market’s sometimes jarring moves. Still, we hope that clients take comfort in knowing that their portfolios are structured to efficiently capture value creation worldwide, and that we’re doing everything we can to take advantage of volatility to optimize returns.

Greg Schick and Sam Lee

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