Long Active Mandates, Short Dirty Benchmarks!
Active and Passive
The investment landscape is divided between active and passive investment management. Active management involves selecting individual stocks or securities to outperform a benchmark, whereas passive management typically focuses on replicating a market capitalization index (benchmark). Over the past few decades, the growth of passive investing has outpaced active management, driven by lower fees and the difficulty many active managers face in beating their benchmarks.
What’s an Active Mandate (AM)?
An Active Mandate (AM) refers to the preference of an active manager (sector, region, asset, factors, etc.) where they would like to build a master universe and then select securities with the goal of outperforming a specific benchmark index. Unlike passive strategies, which simply mirror the benchmark, active mandates involve strategic decisions based on research, analysis, and market predictions. A well-designed, dynamic AM can be a game changer for active managers, allowing them to deliver higher returns and justify higher management and performance fees.
What’s a Benchmark?
A benchmark is a standard against which the performance of a security, mutual fund, or investment manager can be measured. Common benchmarks include market indices like the S&P 500, which represent a specific segment of the market. Benchmarks are often concentrated in certain sectors or large-cap stocks, reflecting the market capitalization of included companies. They are poorly designed. Index fund companies are generally benchmarked to indexing companies, who, in turn, don’t own the indexing methodology, which was written back in 1871, a time before statistics was established as a discipline.
Why Do I Call It a Dirty Benchmark (DB)?
Benchmarks can be considered "dirty" due to inherent biases and systemic issues. These benchmarks, like the S&P 500, create false narratives by forcing comparisons to active mandates. This often misleads investors into believing passive indexes are always superior. SPIVA (S&P Indices Versus Active) reports highlight the struggle of active managers to outperform benchmarks, reinforcing this bias. Active managers are forced to play this game. “I am a concentrated index; you can’t select my magnificent 7. You can only beat me by selecting something else. I own the information of tomorrow’s winners; good luck beating me.” It’s a dirty statistical game. This is why we call it DB.
Selecting from a Larger Mandate
An AM has a default comparison with the S&P 500. They have to select and still beat the benchmark. This is a probabilistic puzzle. Can a manager select a unique subset of stocks that consistently outperform the benchmark? AMs have to work against the probabilistic overhang, as they are forced to differentiate and still be comparable to some version of S&P indexes among the millions of indexes.
Avoiding Benchmark Heist
While making selections, they have to avoid the urge of benchmark fixing. Active managers may engage in practices like fitting their mandate to the benchmark, taking a loose mandate, irrelevant benchmark, or changing benchmarks to appear successful. This is known as a "benchmark heist." To detect if an AM is struggling, investors should examine the manager's annualized performance. Stable, consistent, and marginal performance often indicates potential issues, and due diligence is necessary to uncover underlying problems.
Different Selection Strategies
Asset managers are hence straitjacketed. They have to differentiate their selection to justify their fees. They cannot simply select the top performers ("magnificent 7") and charge for it. Hence designing an active mandate requires a unique selection approach and strategic differentiation, which is explainable, accountable, and profitable to justify the manager’s skill and insight and hence their fees.
Small Selection
An AM cannot hold all 500 stocks in the S&P 500 and expect to beat it. A smaller, more focused selection is essential. Managing a concentrated portfolio allows the AM to implement strategic bets and active decisions, differentiating from smart beta strategies, which often come with lower fees due to their quasi-passive nature.
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Low Tracking Error
To scale successfully, an AM must maintain a low tracking error. This metric indicates how closely the portfolio follows the benchmark. Low tracking error ensures that the AM's performance does not excessively deviate from the benchmark, avoiding investor apathy and maintaining trust.
Low Turnover
Low turnover is crucial for an AM. High turnover can lead to increased transaction costs, front-running, and tax implications, diminishing returns. Emulating the S&P 500’s low turnover helps in maintaining stability and reducing costs, aligning with the benchmark's passive nature while allowing active strategies to flourish.
Passive but Active Perception
An AM that is not purely market-cap weighted may still be considered passive by “high priests.” However, maintaining a passive character while dealing with active perception involves aligning sectoral and regional makeup with the benchmark, ensuring a representative slice of the benchmark composition while maintaining the large-cap biases to keep the AM dirty enough but not dirty like the DB.
FQG and ESG Integration
Incorporating a Fundamental Qualitative Group (FQG) approach involves selecting higher quality stocks based on quantitative rankings, considering factors like liquidity, market cap, and revenue growth. Additionally, integrating Environmental, Social, and Governance (ESG) criteria addresses the essential impact feature which DB does not care about. Despite myths about sin stocks outperforming, ESG-focused mandates, next-generation AMs can create alpha and impact at the same time, while playing the DB’s dirty game.
The 3N Methodology
It was always about probability. The 3N methodology offers a robust framework for building effective active mandates. By combining FQG and ESG principles, it is possible to create portfolios that not only align with investor values but also stand a strong chance of outperforming benchmarks. This methodology emphasizes a comprehensive approach to statistical factors, which allows for stock selection while ensuring low turnover and similar risk.
Conclusion
In conclusion, modern AMs must evolve beyond traditional practices to remain competitive. By challenging the biases of dirty benchmarks and adopting innovative strategies like the 3N methodology, asset managers can deliver superior performance while maintaining ethical and sustainable investment practices. The future of active management lies in its ability to adapt, differentiate, and consistently outperform, paving the way for a new era of investment excellence.
Published Research