The Real Clowns

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I was recently quoted in a Diana Britton article in Registered Rep. magazine entitled, “Is Tactical Investing Wall Street’s Next Clown Act?” As you might guess from the unfortunate title, the writer trots out the familiar and tired arguments for buy and hold investing. In a nutshell, you should buy and hold because:

1. There is no theoretical basis for doing anything else.

2. There is no proof that active management works.

The author goes on to wonder whether active management is just a marketing ploy, and quotes me saying that financial advisors who buy and hold are in the difficult position of asking clients to be patient after a decade of poor returns. The clear implication is that changing to a tactical approach might not be the best investment strategy, but it’s the easiest thing to do when clients demand higher returns.

Let’s review these points one at a time.

Buy and hold investing, also known as strategic asset allocation, has its theoretical roots in a Nobel Prize winning body of work known as Modern Portfolio Theory (MPT). MPT provides an algorithm that, as commonly used, utilizes average returns (means), standard deviation (variances), and correlations to determine the most efficient mix of assets to buy and hold (here, “efficient” describes the mix of securities or asset classes that delivers the highest returns for the least risk). The problem with this use of MPT is that it utilizes historical average data to get to a solution, even though the world is constantly changing and the long-term averages become irrelevant for considerable periods of time. The MPT formula doesn’t recognize the changes in the data. Instead, it gives you one solution for portfolio construction, regardless of changes in the economy. The end result is a portfolio construction that only makes sense if the future returns, correlations, and variances of financial markets equal their averages from the past. While this assumption may be rational, and even statistically and mathematically sound, it’s a lousy way to manage risk. The fact is things change, and markets earn less than average returns when they are expensive. While there is yet no Nobel Prize winning theory to promote tactical and active investing, it does at least offer the comfort of common sense. The theoretical basis for buy and hold investing is a tough case to make once you dig down and understand what you are asked to believe in order for the theory to accord with reality.

Those who continually claim that research shows active management doesn’t work are basing the claim on studies that are irrelevant to the question. The second point — that there is no proof that active management really works — is absolutely true. Of course, there is also no proof that active management, as practiced by Pinnacle Advisory Group, doesn’t work. There’s a reason for that. Virtually every study about active management compares the performance of a style-constrained universe of active managers to a well-defined and easily agreed upon benchmark index. Most studies compare the performance of the universe of equity mutual fund managers to an equity benchmark and find that, on average, mutual fund managers trail the performance of their benchmark. This is typically thought to be because the market is too efficient to beat and because funds carry high fees and expenses. In my book, Buy and Hold is Dead (AGAIN), I discuss the work of Martijn Cremers and Antti Petajisto at Yale University, which presents a third reason for the underperformance: fund managers have become closet indexers. In owning the same securities as the index, they doom themselves to underperform. Using their (Cremers and Petajisto’s) metric of measuring active management, called Active Share, they found that most active managers — the ones who don’t simply mimic the index — significantly outperform on a consistent basis.

But more important than that, the definition used for active management in past studies does not describe what we mean by “active.” Instead of a study where the managers are restricted to owning one asset class, researchers should be looking at the universe of managers who are allowed to own every asset class, with no constraints. Unfortunately, there is no such universe of managers to study! Perhaps the hedge fund world offers a few examples, but the notion of being allowed to invest in any asset class globally with no constraints is so rare that, for now at least, it can’t be studied. So while it is true that I can’t prove the validity of active management beyond offering our own track record of performance, those who continually claim that research shows active management doesn’t work are basing the claim on studies that are irrelevant to the question.

If the challenge is to adhere to an investment philosophy that has the best chance of enabling clients to achieve their financial goals regardless of current market conditions, then tactical and active management is the only practical choice. Finally, there’s the question of active management and marketing. Active managers take on the media and academia in their pursuit of a method of money management that they believe offers clients the best means of navigating dangerous and volatile markets. While articles like this one dismiss active managers as “clowns,” in fact tactical managers are pursuing a craft that requires a great deal of skill. Compare that to buy and hold investors who can pick several mutual funds in a diversified portfolio, check the Morningstar ratings twice a year, ‘fire’ a fund now and then so their clients feel like the advisor is doing something, and then go to client meetings where they basically read the Morningstar fund review, along with the latest news from the Wall Street Journal. For this work, which can be done in a few hours each quarter, they get to charge the same fees as the active managers who dedicate their lives to trying to earn excess returns for their clients. Which of these methods sounds like a better marketing scheme to you?

At the end of the day, buy and hold investing offers clients one methodology for managing risk. MPT tells us, correctly, that diversifying a portfolio of non-correlated asset classes will increase portfolio returns for each increment of risk you take. But MPT says nothing about valuation. Active and tactical managers know that owning overvalued asset classes invalidates every assumption in the buy and hold risk management arsenal. I’m not claiming that active management is easy, or that every advisor should attempt it — in fact, it’s a lousy business model and markets tend to make a mockery of you on a daily basis. However, if the challenge is to adhere to an investment philosophy that has the best chance of enabling clients to achieve their financial goals regardless of current market conditions, then tactical and active management is the only practical choice.

Ken Solow
About Ken Solow
Kenneth R. Solow, CFP®, CLU, ChFC is a founding partner and serves as the Investment Committee Chair of Pinnacle Advisory Group, Inc. As a founding Partner, he was instrumental in creating the tactical asset allocation strategy currently used by Pinnacle to manage $1.3 billion in assets. Solow is nationally known for his views on active portfolio management, and his 2009 book, Buy and Hold is Dead (Again): The Case for Active Portfolio Management in Dangerous Markets, is considered the definitive work on Tactical Asset Allocation. Solow appears regularly at events sponsored by the Financial Planning Association, National Association of Financial Planners, the Investment Management Consultants Association, and the AICPA, and has been published in The Journal of Financial Planning, Smart Money, Financial Planning Magazine, The Baltimore Sun, the Globe & Mail, and the Wall Street Journal.
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