Most fail to produce the alpha required.

In the beginning there was Ben Graham and J.B. Williams working under the premise of “don’t lose my money.” That later evolved into MPT under Markowitz, and CAPM with Sharpe, guided by the principle of “return given the amount of risk taken”. Later, active management had a revival under Ross, Black, Scholes, Kahneman, Grinold, and Treynor. The thinking here was active management remains relevant because investors have behavioral flaws that cause irrational behavior in the markets, thus leading to inefficient pricing. Informational inefficiencies exist and can be exploited by those managers skillful enough to discover them.

But active management today remains under pressure. For the last ten years there has been a steadily increasing flow of funds away from active managers and a steadily increasing flow of funds into index funds and index etf’s. Investment management has been going on for perhaps 4,000 years with the first clear appearance in the Netherlands around 1774. (Eendragt Maakt Magt Investment Trust managing a diversified portfolio of foreign bonds.) But the trend has not been favorable for quite some time. Several reasons are to be found, regulation, increasing competition, and lower priced alternatives. Investment management has always been a history of ideas, some good and some not so good, but with technological advancement and the use of big data, good ideas don’t last long as they are quickly arbitraged away. The alpha produced by active managers (alpha here is the returns from pure alpha and smart beta or factor returns) comes from managers being able to identify the informational inefficiencies existing in the market at any given time.

More and more often active managers are finding it difficult to produce cost adjusted returns comparable with passive strategies as they face new challenges. Most active managers fail to produce the alpha required of them because of their lack of forecasting skills, a failure to incorporate diversification for risk control, or their inability to translate their investment ideas into a portfolio.

At SCI we believe in active management. Our efforts continue to be centered around finding those managers with the statistical likelihood of producing the best alpha compared to the measure of risk taken.

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