There is no doubt that the line between passive (beta) and active (alpha) investing is becoming blurred. “Actively managed ETFs” are a great example. So are “passive” hedge fund replication products that reply on what appears to be an active, albeit primitive, trading strategy. In fact, many investors now recognize that the active management of passive indexes is a primary source of active alpha.
The key to creating “alpha out of beta” is the existence of a set of liquid and transparent indexes. One of the hallmarks of good index is its ability to capture some underlying market dynamic, like the equity risk premium or the price of gold or some “exotic beta”. But an index of active managers?
That’s just what Active Index Solutions has devised. According to the firm’s website, their apparently French-inspired “Actifindexes” were:
“…developed after researching the investment model that the world’s largest and most resourced investors use to select and build their investment portfolio of active managers. These mega investors are typically large pension plans with assets measured in the tens of billions of dollars.”
If this sounds like a fund of funds to you, you’re not alone. In fact, the marketing message is riddled with references to “best in class managers”. So it appears that this product isn’t designed to capture some kind of underlying “smart manager premium”, but is actually designed to produce absolute returns (a worthy goal, but not really an “index” of anything).
Previous indexes of active managers, such as this one by Lipper, aim to replicate not just the hot managers, but all active managers. This makes sense since there may or may not exist an “active management premium” (many say there is, and it’s negative). And furthermore, there is no active management required for an index that involves 100% of active managers.
Unlike Lipper, Active Index Solutions aims to continually pick the top managers – a revolving door of managers that are hot one year and stone cold the next. As we’ve discussed at AllAboutAlpha.com studies have shown weak, if any, persistence in hedge and long-only managers’ ability to continually produce alpha (see related posting).
Still, AIS’s offering has active management written all over it. But it’s not just them. The firm’s three partners on this initiative also don’t seem that interested in just being passive indexes either. Mesirow Financial applies its “PrecisionAlpha” methodology to “seek out alpha”, Klein Decisions uses its “patented decision analytics” and Kanon, Bloch, Carr seeks “consistently strong returns”. In other words, none of them really want to be in the indexing business.
Active Index Solutions (AIS) refers visitors to its website to a 2004 white paper from Duke University on active vs. passive investing that supports index investing. But like most research on this topic, the paper uses passive indexes such as the S&P500 or Russell 2000 – not sub-indexes of active managers.
Those of you in the hedge fund industry may be having a deja vu by this point. Remember back in 2003-2004, when investable hedge fund indexes were all the rage? In direct contradiction of their states objective, index fund managers at the time touted both their performance and their value-adding investment methodologies. Even today, we see this phenomenon at play in the “hedge fund replication” business as suppliers purport to mimic “only the upside” of their target benchmarks.
Howard Present, CEO of AIS’s parent company recently told Investment News that his objective was to capture the momentum of successful managers and combine it with a re-balancing strategy. According to Investment News, he said that “the key was acknowledging the rise and fall of alpha and capitalizing on it while the market is in an upswing cycle“.
We’re not sure what Present was getting at here since, as we point out, alpha persistence is weak at best and even if alpha were predictable, it would – by definition – not “rise and fall” with markets.
Passive benchmark indexes serve a valuable role in the investment management industry (peer comparison, attribution, value-add etc.). But picking the best managers and then treating their concurrent out performance as some kind of indexable factor beta is a self-fulfilling prophecy. It’s as if you arbitrarily chose 10 managers with the best haircuts and used the group as a benchmark for “well-groomed managers”. The question is: Who cares? Do we need to know exactly how suave the index constituents are in order to brush our hair in the morning?