Practical analysis for investment professionals
17 May 2017

The Active Equity Renaissance: Renaissance Portfolio Management

What can we do to inspire the renaissance in active equity portfolio management?

Over the course of The Active Equity Renaissance series, we have dismissed the broken 1970s model of portfolio management and the cult of emotion. We also charted the rise and fall of modern portfolio theory (MPT), considered new frontiers of risk assessment, and discussed behavioral portfolio management concepts.

But how do we revive and sustain active equity?

After Clients, Elevate Buy-Side Analysts to the Starring Role

The Active Equity Renaissance needs torchbearers — those who are committed to helping end clients achieve their goals. That means both buy-side research analysts and portfolio managers. After all, these individuals filter the universe of possible securities, purchasing or shorting assets, and building portfolios through their execution of investment strategies.

They must play the preeminent roles in security selection and portfolio management. For too long, their skills have been undermined by portfolio management guided not by an investment strategy, but by investment intermediaries — consultants, platform gatekeepers, and investment committees. These intermediaries want managers to complete niche style boxes to fulfill an asset allocation strategy they believe is value added in achieving client goals. In other words, portfolio management is too much a product, and needs to return to being a profession.

Naysayers may contend that those whom we hope to elevate are the very people who should be demoted. But until someone proves that intermediaries actually help clients achieve their end goals, there is no reason to discount the expertise of fundamental analysts. Buy-side analysts are quite adept at security selection, according to research. Indeed, this same research offers insight into what choices must be made to deliver value to clients and to defy MPT’s slavish adherents.

Abandon Arbitrary Measures

Benchmarks were originally constructed to measure performance after the fact. Sadly, they have become targets for buy-side research analysts and portfolio managers to manage to before the fact.

To enforce this, investment intermediaries have developed measures — style boxes, style drift, and tracking error — that are entirely arbitrary. Why? Because, again, they want managers to adhere to a niche strategy as part of an overarching asset allocation plan.

Yet, Russ Wermers’s work shows that active managers who comply with such foolishness will be beaten by indexes. After all, active management should be about unleashing the capabilities of the human mind. Why rein these in with unnecessary requirements that destroy client value?

The goal is to beat an index by managing far away from it. Shadowing an index and spending money on researching or increasing the expense ratio is just a formula for expensive closet indexing. Instead, managers should be encouraged to create tracking error.

If a quality value manager, for example, buys a portfolio of undervalued securities, eventually the prices of those securities may appreciate. This, in turn, may lead to style drift, from value toward growth, creating tracking error and style-box violation — all because the manager did the job well!

A look at the academic literature that created these measures shows just how capricious they are. For example, style boxes, like those championed by Morningstar, are the application of identified equity market anomalies, the small-cap and value effects.

Capitalization is entirely arbitrary as a style box. It is a relative delineation of active funds that has little to do with the equity strategies being pursued. The universe of securities is divided into market capitalization thirds, with the smallest third categorized as “small,” the largest as “large,” and everything in between as “mid.” This becomes the measuring stick for manager style drift and often has no relation to the actual management of the portfolio.

The value-core-growth style box is also relative. The book-to-price ratio is calculated for an index, with the highest book-to-price ratio labeled “value.” The lowest book-to-price ratio is called “growth.” Those in the middle are “core.” Once again, management evaluates funds to a standard with little bearing on security selection or portfolio construction, but on securities price movements, which are notoriously volatile.

Managers who want to hold on to the AUM that comes through investment intermediaries must adjust the composition of their portfolios as markets change. Why? Because tracking error, style boxes, and style drift tell investment intermediaries that something is “wrong” and may lead to the assets being pulled from the manager.

In fact, some see style drift as a graver offense than underperformance. Consequently, managers engage in a form of investing legerdemain, or sleight of hand, that has nothing to do with executing their strategy and everything to do with placating investment intermediaries.

Focus on High-Conviction Stocks

Studies show that buy-side analysts are quite good at security selection: Take, for example, the high levels of accretive alpha of their highest conviction/largest positions, as measured by ex-ante relative portfolio weights. Moving down the relative weights, performance worsens, with holdings beyond the top 20 generating negative alpha. In other words, most portfolios are overdiversified and research shows that hurts performance.

This creates a problem for the successful manager who receives large investment flows when performance is good. Due to legislative requirements like the US Investment Company Act of 1940, maximum position sizes — as measured by cost basis — force managers to invest in securities in which they have less conviction.

Too Big? Convert to an Index Fund

Managers who invest in securities they don’t believe in to avoid cash positions — remember that style drift problem! — should consider converting to an index fund if AUM grows too large. How large is too large? Research suggests that AUM close to $1 billion is too large for investment managers. Capping new inflows is also an option. Some funds do this to ensure that their security selection is built around high-conviction positions.

Introduce Performance-Based Fees

Another way to engage in renaissance portfolio management: Introduce performance-based fees.

We are strong advocates for high-water marking fees and performance.

There is a theory that active managers perform better during periods of overall market decline. One way to leverage that is to alter the fee structure to encourage neutral to positive returns in down market periods. If a manager cannot deliver better than a benchmark — say, a highly rated sovereign credit’s return over a similar time horizon — then they shouldn’t be paid for their performance.

Dismantle the Closet-Indexing Factory

The vast majority of active equity investment teams are skilled stock pickers. But many funds transform into closet indexers through asset bloat, benchmark tracking, and overdiversification. Essentially, the industry is a giant closet indexing factory. Funds are strongly incentivized to capture the economic rents generated by their investment teams.

Once the fund becomes a closet indexer, powerful incentives encourage it to stay that way. Today closet indexers harvest internal cash flows amid strong outflows. Why would these legacy funds restructure into truly active funds when it may be more profitable for them to simply wither away?

Our best hope is to steer new entrants away from becoming value-destroying closet indexers.

Dismantling the finance industry’s closet indexing factory is a critical step in The Active Equity Renaissance.

At the 70th CFA Institute Annual Conference, which will be held 21–24 May 2017, C. Thomas Howard will discuss ways that active equity mutual funds can be evaluated through behavioral concepts during his presentation, “The Behavioral Financial Analyst.”

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/Elena Pueyo

About the Author(s)
Jason Voss, CFA

Jason Voss, CFA, tirelessly focuses on improving the ability of investors to better serve end clients. He is the author of the Foreword Reviews Business Book of the Year Finalist, The Intuitive Investor and the CEO of Active Investment Management (AIM) Consulting. Voss also sub-contracts for the well known firm, Focus Consulting Group. Previously, he was a portfolio manager at Davis Selected Advisers, L.P., where he co-managed the Davis Appreciation and Income Fund to noteworthy returns. Voss holds a BA in economics and an MBA in finance and accounting from the University of Colorado.

Ethics Statement

My statement of ethics is very simple, really: I treat others as I would like to be treated. In my opinion, all systems of ethics distill to this simple statement. If you believe I have deviated from this standard, I would love to hear from you: [email protected]

C. Thomas Howard

C. Thomas Howard is the co-founder, chief investment officer, and director of research at AthenaInvest. Building upon the Nobel Prize-winning research of Daniel Kahneman, Howard is a pioneer in the application of behavioral finance for investment management. He is a professor emeritus at the Reiman School of Finance, Daniels College of Business, University of Denver, where he taught courses and published articles in the areas of investment management and international finance. He is the author of Behavioral Portfolio Management. Howard holds a BS in mechanical engineering from the University of Idaho, an MS in management science from Oregon State University, and a PhD in finance from the University of Washington.

4 thoughts on “The Active Equity Renaissance: Renaissance Portfolio Management”

  1. Fung C.F. says:

    Hi Jason & Thomas, another great piece, well done! Always learn something from your post.

    I believe Baupost is a great case study for this discussion (I’m a big fan of Seth Klarman anyway). They have been very successful in active management and they can somehow be related to all of your points.

    1) Essentially, their funds are managed by “analysts”. If research and security selection are not the most important aspect of portfolio management, what is?
    2) Absolute-return benchmarking and comparing the after-results to market return (as you pointed out) make more sense, and Baupost does it in style. Watching the variance between your return and index return everyday/week/month is not only a waste of time, it also distorts strategy and encourage short-term thinking. (The style-box thing is not even worth discussing here)
    3) Focusing on high-conviction stocks is obviously the most sensible thing to do, but strange enough that not many people actually doing it. Again, Baupost does it in style. Diworsification is the popular way to go for most funds.
    4) Baupost is closed for inflows. Size is the enemy of performance, and Baupost knows it well. Ironically, most funds feel “unsafe” for holding big cash position, unlike Baupost.
    5) It really surprises me that so many capital providers are willing to dish out non-performance-based-fee mandates to active managers. If performance is not the measurement of compensation, what is? Yet, many of them are willing to pay a percentage fee over the AUM regardless of results.
    6) I have not heard of any successful closet-indexing manager in my life (they are many rich closet-indexing managers though).

    1. Hello C.F.,

      Thank you for your excellent description of key success factors. Not surprisingly, for the fund that I managed we met each of the criteria above, except that we were not closed to new investors because the amount of the fund’s AUM was less than US$1 billion in 2005 monies. In fact, it was discussion of these factors that led to Tom and I connecting several years ago. We found that there was overlap in terms of process. Later, Tom’s research confirmed what we knew.

      With smiles,


      1. Mark Bechtle says:

        1. It is called THE STOCK MARKET for a reason….
        2. Compounding is the goal.
        3. Single stocks are the fastest way to compound wealth.
        4. Concentration is the focus.
        5. Concentration in compounding stocks is the equation.
        6. Concentration in compounding stocks creates wealth.

        1. Hello Mark,

          Thank you for your comment.

          With smiles,


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