Systematic Relative Strength

Well, it wasn’t actually Galileo this time. This time the reigning orthodoxy was rejected by Dr. C. Thomas Howard, a professor of finance at the University of Denver. Dr. Howard has seen the light. As CEO and director of research for AthenaInvest, he had the opportunity to review a lot of manager data. But instead of trying to fit it into a decrepit framework, Dr. Howard interpreted the data with fresh eyes. He describes his conversion process in an article in Financial Planning magazine.

Conventional wisdom suggests that hiring an active equity manager is a fool’s errand. I once believed this too, as did many of my academic contemporaries enamored with an elegant yet flawed notion of efficient markets.

Many advisors have since jumped on the bandwagon, believing that hiring an active manager represents the triumph of hope over reality. The passive parade has only grown more popular in recent years, proudly marching through the last decade with no excess returns to show for it.

When I received my PhD in the late 1970s, the popularity of the Efficient Markets Hypothesis and Modern Portfolio Theory were approaching their zenith. As an early believer, I even demonstrated these concepts to my students with a dartboard.

Yet before long, the Capital Asset Pricing Model began failing empirical tests. The Efficient Markets Hypothesis now resembles Swiss cheese, rather than a foundational concept.

What did he see when he started looking at the data that changed his mind?

When active managers are separated from their index cousins, a different picture emerges. By studying this question, I’ve found it possible, as have some of my academic peers, to identify active managers capable of generating excess returns.

This puts us at odds with many outspoken members of the financial planning community. But the drumbeat of peer-reviewed evidence only grows louder as we turn from our collective infatuation with indexing.

When they do their job skillfully, active equity managers exploit market inefficiencies others choose to ignore. It only makes intuitive sense that, with the vast resources available, superior stock- picking skill is regularly demonstrated by active equity mutual fund managers.

I’ve found this to be especially true when these same managers are unconstrained by style box mandates and take high-conviction positions. Rather than being rare, excess returns are plentiful.

I think Dr. Howard’s journey is going to become more and more typical, as academic notions of how markets operate are repeatedly trampled by evidence to the contrary. (The bold is mine.) He is to be commended for writing such a powerful article in an industry organ with such wide circulation. It’s really not that difficult to identify sources of excess returns—as he says, other professors have had the same epiphany and, like Dr. Howard, often end up in the money management business as a result. What I think is unusual, and laudatory, in the case of Dr. Howard is his call to action:

…the active versus passive debate has grown stale. The question we should ask is: Do we have the courage to act on the ample evidence?

This is the essence of Behavioral Finance - that markets make pricing errors consistently. Do we choose to follow the noisy marching band, no matter how bad the tune, or listen to the evidence and pocket excess returns for our clients?

AthenaInvest, rather than categorizing managers by style box, sorts managers by strategy. This, I think, makes far more sense than the typical framework. We’ve often written about how relative strength and value, as contrasting strategies, complement one another in portfolio construction. I would guess that a skilled practioner could reap excess returns from a variety of strategies.

Behavioral Finance = Emotional Asset Allocation in action. Think about excess returns this way: even John Bogle argues that the market return is all that is available to market participants in aggregate. Bogle’s argument is that since many investors do worse than the market (think pension funds and DALBAR-driven retail investors), you’re better off just buying an index fund.

But what about the flip side of the argument, the one Mr. Bogle doesn’t want to acknowledge? If aggregate participant returns are exactly equal to market returns, but many participants can be demonstrated to do much worse than the market, who is getting all of the excess returns that pension funds and retail investors aren’t getting?

As Dr. Howard points out, excess returns may actually be plentiful for those skillfully executing a winning strategy. (No doubt some of the excess return is also going to the croupiers.) Passive investing is more an admission that you can’t figure out how to reap excess returns than a statement that they don’t exist. I’m not going to argue that fighting for excess returns is easy, but the evidence shows that it is possible. So what about you—are you going to knuckle under or have the courage to act on the evidence and try to capture the excess returns that are available?

Source: AthenaInvest, www.etc.usf.edu