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BehavioralMattersInsights from the application of Behavioral Finance | Issue 41
BewarePassive
InvestingBy: Michael A. Ervolini, CEO
February 28, 2017
INTRODUCTION
Active management is tough business. Once alpha-generating strategies can lose their luster in a
quarter or two, helping to explain why 4/5 of active funds underperform each year. The challenges
facing active management — particularly the competitive threat of passive products — have never been
greater. In response, traditional investment management companies have launched a host of initiatives
to fortify their businesses including: creating custom portfolios to match unique client requirements,
establishing their own index and ETF offerings and revamping marketing/customer relationship services.
Less frequently observed are concerted efforts directed at improving skills, processes and ultimately
performance: not improvement as an aspirational goal as it is generally approached, but improving
deliberately using rigorous feedback and a scientific method. This essay takes a hard-nosed look at the
pummeling being taken by active management and argues that improving can no longer be approached
passively and that it must become a core competency for every active manager.
“Nobody is going to save you but yourself and the best and only way to do so
is through action.”
- Oli Anderson
Behavioral Matters is a series of essays on the application of Behavioral Finance written specifically for professional investors and portfolio managers.
© 2017 CABOT INVESTMENT TECHNOLOGY, INC. // BEWARE PASSIVE INVESTING: ISSUE 41 | 2
TSUNAMI
The global shift in assets away from active to passive products, while already substantial, is about to hit
its full stride, according to Moody’s Investor Services. In a recent report, they state: “Passive investments
– ETFs and index funds – account for $6 trillion of global assets. Now 28.5% of assets under
management (AUM) in the US, their US market share is rapidly expanding, driven by lower cost and
better performance relative to actively managed funds.” Moody’s goes on to project that within the U.S.
passively managed assets will exceed those actively managed sometime between 2021 and 2024. They
further estimate that between 5%-15% of assets in Europe and Asia are managed passively today but
expect this proportion to grow significantly in the near-term.
Moody’s believes this capital reallocation reflects, in large part, investors reassessing their options: "The
main driver of flows out of active funds into passive funds has been investors' growing awareness that,
by definition, actively managed investments, in aggregate, cannot deliver above average performance,
and that investing is therefore a zero-sum game – for every winner, there must be a loser(s).” An
additional driver cited is changing regulations: “Passive investments' expansion has been further
supported by global financial regulation, which has encouraged greater disclosures of fund fees and
potential conflicts of interest.” The report adds: “In practice, it will become more difficult for advisors to
place their clients into higher cost and more complex investment products.” All of which will impact
asset aggregation the report concludes: “Selling low-fee index products, on the other hand, will eliminate
many apparent conflicts of interests and minimize an advisor’s fiduciary risk.”
“Within the U.S. passively managed assets will exceed those actively managed
sometime between 2021 and 2024.”
“
© 2017 CABOT INVESTMENT TECHNOLOGY, INC. // BEWARE PASSIVE INVESTING: ISSUE 41 | 3
Active management is ill equipped to achieve meaningful
improvement currently due to the heavy dependence upon
folklore and poor feedback to support learning. Expressions of
folklore recited routinely include: it is a good sell as long as the
proceeds are reinvested in a winning buy; growth managers are
more likely to exhibit the endowment effect; and managers that
beat their benchmarks do so primarily by purchasing great
names. Comforting as these and other investment truisms feel
they are often wrong, as borne out by Cabot’s analysis of more
than $2 trillion of professionally managed assets.3 Reliance on
such pseudo-facts gives individuals a false sense of their own
strengths and shortcomings, making it near-impossible to
improve.
Poor feedback is what inhibits self-awareness and improving.
What type of feedback specifically? All of it! Conventional metrics
such as: relative return, information ratio, tracking error, alpha,
attribution analysis and hit rates are merely scorecards. They
provide useful information about past performance yet they say
nothing about the manager’s strengths and weaknesses.4 Most
importantly, they cannot guide the manager to the one thing she
should do today to become a better investor tomorrow.
Improving requires facts not hunches, and needs to be driven by
rigorous analytics not emotionally laden recollections or reliance
on comforting narratives.
STRUCTURAL SHORTCOMINGS
IMAGE HERE
“Reliance on pseudo-facts
gives individuals a false sense of
their own strengths and
shortcomings.”
© 2017 CABOT INVESTMENT TECHNOLOGY, INC. // BEWARE PASSIVE INVESTING: ISSUE 41 | 4
How do you generate most of your portfolio’s performance, from buying or selling? The answer
probably came to you before you finished reading the prior sentence. But how do you know? You can’t,
not for sure. Knowing implies the availability of data-driven facts such as: my buying generates over 175
basis points of relative return annually while my selling, which used to cost the portfolio 225 basis
points, is now neutral. Lacking rigorous feedback like this you’re just guessing. And as the Moody’s
report makes clear — guessing ain’t getting it done.
Fortunately, a new analytic framework that supports learning and improving now exists. The new
framework enables you to quantify skills, processes and behavioral tendencies. Armed with this clear
feedback you can set about becoming self-aware and improving deliberately. This framework is being
used by hundreds of professional investors around the globe and the results are impressive. Portfolios
engaged in deliberate improvement are, on average, adding approximately 45 basis points of
incremental relative return year after year.5 These managers are using their processes to do more of
what they do well, to improve where needed, and to eliminate unproductive behavioral tendencies.
The analytic framework and how it supports improving are fully described in: “Managing Equity
Portfolios: A Behavioral Approach To Improving Skills and Investment Processes,” by Michael Ervolini,
MIT Press. Mike’s book also includes seven ideas or projects that will allow you to begin improving
deliberately right now.
NUMBERS YOU CAN COUNT ON
“Portfolios engaged in deliberate improvement, on average, add
approximately 45 basis points of incremental return year after year.”
“
© 2017 CABOT INVESTMENT TECHNOLOGY, INC. // BEWARE PASSIVE INVESTING: ISSUE 41 | 5
CONCLUSION
© 2017 CABOT INVESTMENT TECHNOLOGY, INC. // BEWARE PASSIVE INVESTING: ISSUE 41 | 6
ENDNOTES1. Anderson, Oli, “Personal Revolutions: A Short Course in Realness,” CreateSpace Publishing, 2016.
2. Moody’s Investor Services, “PassiveMarket Share to Overtake Active in the US No Later than 2024,” February 2, 2017.
3. Buying and selling should, in fact, be evaluated separately which leads to a good sell being one where the position sold goes on to
underperform the manager’s portfolio. The endowment effect or holding onto winners too long is found in every type of portfolio
(i.e., growth, value, core, benchmark agnostic, etc.). Many successful managers derive most if not all their excess return from
strong selling and/or position sizing, often in conjunction with neutral or negative buy skills.
4. A more expansive discussion on this topic can be found in Chapter 2 of “Managing Equity Portfolios, A Behavioral Approach to
Improving Skills and Investment Processes,” by Michael A. Ervolini, MIT Press, 2014.
5. Based on a study of over 80 professionally managed portfolios across a five-year timeframe. For more information see:
“Improving Deliberately”
Passive investing is now hitting its stride and soon will be lapping
active management in the US and the same is expected throughout
Europe and Asia in the not-too-distant future. As Moody’s explains
it: “Investors will continue to shift to beta investments, whether
smart, simple or exotic, given their lower costs, better performance
and transparency.” In light of this assessment, approaching
business as usual will, for a number of management companies,
likely segue into “out of business.”
In contrast to the troublesome asset reallocation occurring,
improving how well you invest is completely within your control.
There is plenty of evidence to suggest that if you approach
improving passively you are all but doomed to deliver passive
results, or less. There is no sensible argument for not wanting to do
your best for your clients and that can be achieved only through
deliberate improvement. Of course, actively engaging in deliberate
improvement may not assure you a place on “the stairway to
heaven” but taking a passive approach to becoming a better
investor will surely result in a terminal case of the “Moodyblues.”
INSERT IMAGE HERE
Cabot helps equity portfolio managers and
research analysts improve. Using our
proprietary patented analytics we help
investment professionals better understand
their skills, investment processes and
behavioral tendencies. Clients then collaborate
with Cabot to implement pinpoint refinements
to the way they buy, sell and size assets.
COPYRIGHT © 2017 | CABOT INVESTMENT TECHNOLOGY, INC. | 11 BEACON STREET, BOSTON, MA 02108
www.cabotintech.com
READY TO IMPROVE DELIBERATELY?
CONTACT CABOT
Improvement of more than 150 basis points of incremental performance is typical
among clients during their initial three years of Cabot collaboration. In addition to
generating stronger results, these investment professionals gain deeper self-
awareness, streamline their investment processes and build stronger relationships
with their investor-clients aided by compelling charts, graphs and other
communication tools. Knowing is better than believing – if your goal is to do your
best today while learning and improving for tomorrow, then we’re here to help.
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