Why Active Management Can Come Up Short


28/04/2016 11:46:14 PM // Written by Phil Stockton

Why Active Management Can Come Up Short

Why Active Management Can Come Up Short

In the QE era, passive investing looks to have come out on top of active management. Primarily, passive investing is less expensive than active management but there have to be other factors that explain the difference in performance. In a BloombergView piece, seasoned investor Barry Ritholtz hypothesizes on some of the likely contributors to active managers’ collective woes.

 

Ritholtz also introduces his readers to factor-based or evidence-based investing.

 

“Alpha is really only factor-based investing: What was once believed to be outperformance might be explained by specific portfolio characteristics, such as momentum, earnings quality and other features. Once these so-called factors and any additional risk are accounted for, the alpha all but disappears.

 

Nobel Prize winner Eugene Fama and Kenneth French developed the five-factor asset pricing model in which they found that various factors can account for “between 71% and 94% of the cross-sectional variance of expected returns.” In other words, alpha is more the result of these specific factors than most investors realize.”

 

We’re sure that you will agree that this five-factor evidence-based model sounds interesting; here is a little more on the topic as well as an introduction to its practical application:

 

The five-factor model developed by Eugene Fama and Kenneth French (Directors of Research and Investment Strategy at Dimensional Fund Advisors respectively) explains much of the variation in returns in equities and income markets. Dimensional has been designing and implementing portfolios around these five dimensions in different forms since their inception in 1981. David Booth (founder and co-CEO of Dimensional) was assistant teaching professor to Fama at the University of Chicago and was the first practitioner to implement Fama’s theories when he pioneered the world’s first index fund in 1971.  As the academics learn more about the dimensions of return (five factors), Dimensional take these ideas and implement them to improve the strategies for clients - it’s a pretty cool partnership. In effect, Dimensional become the research and execution team for the financial advisory firms they work with around the world, and they use this evidence-based investment philosophy to add value to their clients' over index funds and traditional active management. What’s really cool is that Dimensional do this for fees typically associated with leading passive ETFs.   

 

We will further explore both the five-factor model, evidence-based investing and Dimensional in coming blogs. For now here is the Ritholtz piece that inspired today’s blog. Enjoy, we did. If you want to read more you can do so here on the CFA Institute’s site. 

 

 

 

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