How to use active investing to outperform

A recent blog examined the seven lessons from the financial crisis that should be incorporated into client relationships.

One was that passive investing is not riskless. However, even if an investor acknowledges that investing in an ETF involves risk, the next question is whether there is adequate reward, and whether the approach is optimal.

Of course, there are numerous benefits to investing in ETFs. But within equities, where transaction costs are quite low, there are some structural issues.

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One of the fundamental concepts of investing is that risk can be reduced through diversification, and index ETFs are inherently diversified. However, the relationship between reduced risk and increased diversification is not linear. There’s a point at which adding more stocks makes no discernible difference to risk and may dilute potential returns.

As Buffett said, “Wide diversification is only required when investors do not understand what they are doing.” ETFs are essentially the embodiment of this over-diversification.

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In addition to over-diversification, index ETFs are flawed due to the relative weight that’s assigned to each holding in the portfolio. In an ideal world, the investments with the best risk/return characteristics have the largest weightings.

But within an index, stock weightings are random because they’re based on the market capitalization of each company. There may not be a relationship to returns.

So if index ETFs have structural issues, what are the alternatives for investors who don’t have the experience to manage their own equity portfolios?

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Mutual funds have been the solution for many over the past several decades. Unfortunately, many large mutual funds have structural liquidity issues that make it difficult to outperform their relevant indices.

As their business models are based on generating management fees that grow as AUM increases, most mutual funds are incented to focus on building that metric.

And as these funds become large, many investments fall outside of their investable universe because the stocks are not liquid enough for a large fund to invest in. As a result, these funds end up having the greatest exposure with the largest market capitalizations, which makes their portfolios comparable to the index.

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Against this alternative, ETFs begin to look attractive.

Active managers with a full range of investment options who construct portfolios different from the index can outperform, notes a study by Yale’s K.J. Martin Cremers and Annti Petajisto. They created the concept of Active Share to measure the percentage of the portfolio holdings that differed from the benchmark index holdings.

Not surprisingly, the funds that were able to beat their benchmarks over the long term were ones that had high Active Share. Those with low Active Share (like the majority of mutual funds) were unable to overcome the costs of their fees.

High Active Share is not the only determinant of outperformance, but it’s an important starting point for the investor who is interested in optimizing risk and reward.

Andrea Horan, CFA, Principal Prior to helping found Agilith Capital, Andrea Horan was a founding partner at Genuity Capital Markets where, as a member of the Partners Committee and Director of Research, she built and managed a department of 15 analysts. She has been engaged to speak at a number of industry events, contributed to investment publications on the subject of media investments and provided expert advice to the CRTC and the Canadian Federal Government.