By: Barton Waring, Barclays Global Investors & Laurence Siegel, The Ford Foundation
Published: June 2005, Journal of Investing
This is an excellent article that debunks several time-honuored marketing pitches used by active managers – and by extension hedge fund managers. Waring & Siegel say:
“We strongly believe that in the presence of skill active management can be successful. But we also believe it can be sold on its own merits without artificial arguments. So here we debunk some of the myths and stories often told in support of active management. We fear they do more harm than good, and sow confusion, misunderstanding, and ultimately distrust of healthy management disciplines.”
Waring and Siegel argue that many (most) active managers don’t properly understand the extent to which their returns are driven by beta.
“Good managers know the difference between true alpha and market returns. And they know that active management is a zero-sum game…”
While uncorrelated “absolute” returns are often touted as the ultimate in active management, the authors argue that reducing beta exposure can actually be a bad thing if it confounds the client’s policy mix. In other words, there is often method in the madness of a high beta exposure. (Still, there may not be method in the fees charged by active managers for beta exposure that can be purchased separately for close to 0%).
“…if youâ€”the investorâ€”really want less exposure to that benchmark (a market risk decision), a benchmark that was chosen during your strategic asset allocation (SAA) process, wouldn’t you have made that decision in the course of that process? You chose to take the level of market risk represented by that benchmark, because you expect it to be rewarded over time. You don’t want your manager to take you persistently out of the market by carrying a low beta. Managers are hired to deliver pure alpha, not to make unauthorized changes in your exposures to market risk from that you specified in your SAA policy.
Waring & Siegel also prophesize about the business changes that will accompany a focus on alpha-generation. Regular readers of AllAboutAlpha will recognize some of these themes from a recent posting on a study about the future of the asset management industry.
“…the good manager today is less likely to be one single smart person, or even a small group of smart people managed by a single smart person. Instead, we are finding that an increasingly effective model of good management is to finally move from the preindustrial period of building one handmade musket at a time, using individual, nonstandard crafts, to Eli Whitney’s industrial model, where smart people organize an entire process and build a lot of identical muskets (much more cheaply and efficiently) using interchangeable, mass-manufactured parts. The analogy in investing is to create processes that concentrate and refine the essential inputs that generate the desired end-productâ€”in this case, alpha. Today, the best processes are likely to be industrial-strength information management and evaluation systems, built and directed by teams of smart people looking for insights that are generalizable across large numbers of securities, rather than individuals or small teams of people trying to pick one security at a time.”
The paper addresses several common questions raised by the marketing assertions of asset managers:
- “Should you use active management rather than index management in the less efficient markets like international equities, small-cap equities, or emerging markets?
- “Is it possible through special techniques to generate higher returns than the market, while taking less risk than the market?”
- “Some traditional active managers claim they simply match the benchmark in up markets, but that they beat it in down markets. How can I test this claim?”
- “Should I hold active managers instead of index fundsâ€” so that someone can move me in and out of the market to protect the fund’s value in volatile markets?”
Alpha Male recommends this paper to anyone tasked with the unfortunate, yet entertaining, task of judging an asset management “beauty contest”.