The most successful investment strategy is one that you can stick with. We can't design such a strategy without first forming reasonable expectations around the possible risks and rewards involved. Whilst this is largely an evidence driven process, some intuition is required to understand the key factors that determine whether our evidence can be applied in a certain scenario.
Let's explore this using a hypothetical decision on whether or not to invest passively, use a factor based approach or hire a fundamental active manager. How do we go about deciding which way to invest?
A long time friend and mentor once explained the challenge to me as:
Friend: What’s the typical institutional fee for a fundamental global equity fund manager?
Me: between 0.5% and 0.75% basis points depending on the strategy.
Friend: OK, let’s assume the fee is 0.5%. Let’s also assume they’re skilful, that is they have an information ratio of 0.5 over the long-term and they take a reasonable amount of active risk, for example a tracking error of 5%. How much would you expect them to beat the market by?
Me: With a tracking error of 5% and an information ratio of 0.5, I’d expect them to beat the market by 2.5% over the long-term.
Friend: OK, that sounds fair. What percentage of active global equity fund managers under-perform the market over any one-year, three-year or ten-year period?
Me: It varies, but it’s usually between 60-90%.
Friend: Let’s assume it’s 75%. The expected value of your alpha from selecting that manager is expected alpha multiplied by the probability of selecting a manager that out-performs or (5% × 0.5) × (1-0.75) = 0.5%.
The fund manager has captured the entire expected value of alpha!
You may ask, what's the point of this conversation? Ultimately there are four variables that matter when deciding whether or not to invest in an active investment strategy:
1. level of active risk
2. fee paid
3. manager skill
4. your skill in selecting the manager
The decision to invest actively depends on how your circumstances relate to these four variables. It’s as simple as that. Figuring your circumstances out requires some honest self-examination. A good place to start would be to answer questions such as:
1. How much active risk am I comfortable taking? Can I patiently invest through ups and downs in the market? Will I stick with my chosen strategy even if it under-performs the market for several years?
2. How much will it cost me to invest? Do I have any negotiating leverage (e.g. a large institutional investor offering seed funding) that can swing the equation in my favour?
3. Is the manager skilled? Or, is the manager investing in an opportunity set where the competition is weak?
4. Do I have an edge that shifts the odds of finding a market-beating manager in my favour?
Of the four variables, the fee paid is clearly the most powerful. It's elementary, the lower the fee paid, the more that is left over for you . The Fee is also the most reliable of the four, it doesn't take a genius to realise that what you save is what you get to keep.
This article was adapted from an earlier piece written by Daniel Grioli.