A new book entitled Winning at Active Management: The Essential Roles of Culture, Philosophy, and Technology, co-authored by William Priest, CEO at Epoch Investment Partners, addresses the reasons behind the difficulties active managers are facing as well as some strategies they can use to overcome them. An excerpt of the book was recently published in Barron’s.
It argues against the notion that recent underperformance indicates efficiency of the markets. Instead, it suggests that active managers must be able to understand the underlying causes of price inefficiencies in order to exploit them and, further, must recognize that they are subject to behavioral biases like any investor.
Two common errors and examples cited:
- The sensitivity of managers and their clients to benchmarking performance against returns of the broad market. A manager might believe a stock is highly overvalued but still takes a position if it makes up a small percentage of the benchmark index (lest excluding it hurts the strategy’s relative return).
- The “drumbeat” of performance review against indices has caused many managers to shorten their investment horizons. A manager might believe a company is undervalued and that over the next few years, the market will recognize it and correct the disparity. But if his clients are unwilling to tolerate performance below the benchmark for more than a year, he may not be willing to chance a position.
Active managers, the authors argue, should identify and take advantage of “stock-specific inefficiencies” by adopting a disciplined investment process that includes:
- Understanding the economic forces that create inefficiencies;
- Capturing them by “casting a wide net” across stocks likely to be affected;
- Structuring portfolios so that returns are driven by these inefficiencies.
“Most active managers,” it says, “fall short in one or more of these dimensions. If that’s the case, then underperformance by so many active managers does not constitute proof that generating excess return is impossible. Instead, it demonstrates that outperforming the market is very difficult, and suggests that most managers follow a flawed approach to investing.”