A Little Goes a Long Way - The Value of Highly Active Strategies

Nov 11

Background

Most active managers do not justify their existence because they underperform the major market indices. In fact, many active strategies struggle due to high fees, market efficiency, and over-diversification that dilutes potential returns. Nearly all underperform their benchmarks on a net basis over long periods of time on an unlevered basis. Finding significant sources of long-term alpha is hard. Much of the active asset management industry tries to marginally outperform indices, but even one or two bad years can set them back permanently. They are often considered “closet indexers” – active managers who closely mirror index performance while charging higher fees, relying more on marketing and client inertia than true outperformance.

We think closet indexers should disappear from the asset management industry over time – the low-fee passive alternatives are simply too difficult for most of them to outperform over time.

The passive products in the market are great and should constitute the majority of most long-term investors’ equity portfolios. Low fees and market-matching performance make passive ETFs attractive for the core of any portfolio. However, as great as the passive options are, incorporating highly active, performance-based strategies into a portfolio heavily concentrated in ETFs can be highly additive to overall performance, without being too risky to overall future performance.

We started Recurve to be additive, not substitutive, to the passive investment trend. Our approach to active management is to be HIGHLY active – to specialize in what we do best, invest with a more concentrated portfolio, and target high returns. Our strategy isn’t about following the crowd but about intentional, high-conviction investments that have the potential to add significant value. It is a boutique approach within the much larger asset management industry, but we strongly believe this type of strategy deserves consideration in every investors’ portfolio.

To be clear, highly active does not mean high transaction volume. We define “highly active strategies” as those that intentionally pursue high-returning strategies that deviate significantly from the overall market’s performance over time. We also differentiate “highly active strategies” from “risky strategies” in that they utilize more disciplined risk controls on portfolio construction, use of leverage, position sizes, liquidity (or lack thereof), etc. The continuum below shows how we classify active managers relative to their deviation from 100% passive ETF exposure.

We think most investors should consider allocating 5-15% of their equity portfolios – sometimes less, sometimes more, depending on circumstances, risk tolerance, and timelines – into highly active strategies, and should largely avoid closet indexers. Let’s walk through some scenarios to demonstrate why we think highly active strategies can be nicely accretive, especially on a risk-adjusted basis.

A Little Goes a Long Way

The beauty of supplementing the breadth and broad market participation of the passive benchmark with even a small allocation to highly active strategies is that investors can generate nice upside skew without risking too much underperformance compared to a portfolio of 100% passive options. Below we will walk through some examples – first of an 85% passive ETF/15% highly active allocation mix, then of a 95%/5% scenario.

Examples – 85%/15% and 95%/5%

Let’s evaluate the performance of $1,000 invested over a 25-year investment horizon for a couple of scenarios. First, let’s assume $1,000 will be invested in a passive-only composite of ETFs. That passive-only composite would generate pre-tax asset value of $6,848 over a 25-year period, earning 8% per year annualized.

Next, let’s evaluate if an investor allocates $150 of the original $1,000 to a highly active strategy targeting 15% annualized returns, and $850 to the same passive strategy above. The $850 of passive assets would turn into $5,821 of gross asset value. In the chart below, we show the band of performance for the aggregate portfolio value using the high case (15% annualized, outperforming by +700 bps) and a low case (3% annualized, underperforming by -500 bps).

In the high case, the investor’s gross asset value would be $10,759 – a +57% premium to the passive-only option. In the low case, the investor’s gross asset value would be $6,135, a -10% discount to the passive-only option. This is the kind of upside skew that investors should get excited about. They get broad, market-level participation for the majority of their allocation, but can enhance returns with a small allocation to highly active strategies, creating a high upside/low downside skew. In the high case, gross annualized performance would rise from 8% for the benchmark to 10% for the portfolio. In the low case, annualized performance would fall from 8% to 7.5%.

One caveat is that we are not contemplating the tax efficiency of the active strategy, which is an important consideration. We touch on this topic below.

Now, let’s look at the benefits of even a small allocation in a 95%/5% portfolio. As shown below, even a 5% allocation to a highly active strategy can generate nearly 20% of accretion in the high case, with only -3% risk to portfolio in the low case. The upside case would create gross asset value of $8,152, while the downside case would generate gross asset value of $6,611. Again, a great skew on the “risk” portion, nearly 7:1, but with less absolute upside potential compared to the 85%/15% scenario.

What Constitutes a Highly Active Strategy?

Next, let’s discuss some of the markers of firms and products that are highly active and not closet indexers. These characteristics apply to public equities and may or may not apply to other asset classes.

1. A thoughtful investment strategy. The investment strategy should make intuitive sense. It should be backed by years of proven results, whereby a manager can translate the strategy into a verified, cause-and-effect track record. If a manager cannot explain the main drivers of his or her performance through demonstrable case studies, there may have been a high degree of luck involved.

2. Heightened focus. On a theme, on a sector, and/or in a portfolio. If a firm, fund, and/or team is targeted and focused, it is more likely to be highly active. From the investor’s perspective, this is great – they have plenty of diversification from their passive investments, so they should want hyper-specialization among their active allocations.

3. Long-term investment horizons. Long-term outperformance can be generated in a multitude of ways, but the best performance on a net, tax-adjusted basis are generated through long-term, patient ownership. A UC Berkeley study in 2000 found that households that trade frequently earned a net annualized geometric return of +11.4%, while those that traded infrequently earned +18.5%. See the chart below which shows similar gross performance across trading quintiles, but vastly inferior net performance for high-turnover, shorter-term strategies. Shorter-term strategies must significantly outperform longer-term strategies on a gross basis to generate the same net returns, but few of them do.

*Source: “Trading is Hazardous to your Wealth: The Common Stock Investment Performance of Individual Investors,”* Brad M. Barber and Terrance Odean, *The Journal of Finance*, April 2000

4. Tolerance of volatility. Highly active investment firms attempting to beat the market handily over time tend to be tolerant of volatility – on the way up and during drawdowns. Most people think about tolerance for downside volatility which is important for not getting shaken out at the lows over long-term horizons, but it can be equally difficult to tolerate significant outperformance psychologically. Many biases and market forces pressure active managers to reduce exposure to their best performers to avoid mean-reverting in the short-term. Many active managers succumb to those pressures and miss out on significant gains from their investments.

5. Appropriate risk management. Every investment strategy – even highly active ones – must be paired with a thoughtful risk management framework. The goal is to generate returns within acceptable risk thresholds, not shoot for the moon. This applies to position construction and sizing, portfolio leverage, and more. For example, many public equity hedge fund companies have incorporated private investments into their portfolios. Investors should be aware of compositional changes like this and their impact to their portfolios’ overall risk management.

Conclusion

Hendrik Bessembinder at Arizona State University has conducted long-term studies on stock returns. The punchline: “The mean outcome across stocks is a cumulative compound return of 22,840%, or equivalently, final wealth of $220.40 per dollar initially invested. However, the median outcome across is a cumulative compound return of -7.41%, as 51.64% of stocks realized negative compound returns over their full lives in the CRSP database.”[1] Investing in the indices gives an investor performance closer to the mean returns. However, we see from his research that the majority of stocks underperform, and a small minority of stocks generate life-changing performance. Owning sizable positions in some of the best performers can create significantly differentiated, index-beating performance.

Most investors want to make sure they participate in the long-term performance of the American economy. They can ensure that they do that by having sizable “anchor” positions in the major index ETFs. However, we believe investors would benefit from allocating a small share of their overall portfolio to highly active strategies to enhance their long-term performance without sacrificing much downside.

Additionally, we believe that the “closet indexer” industry should be disrupted and eventually eliminated from the asset management industry. This trend has begun already, as evidenced by the rise in passive ETF assets under management. Cheaper, more liquid, more efficient passive products exist – especially on a post-tax basis. Investors don’t need a thousand options of closet indexing “large cap growth” or “small cap value” funds that will mostly underperform their benchmarks, but their portfolios and long-term investment performance could benefit from exposure to boutique managers running highly active strategies.

[1] “Which U.S. Stocks Generated the Highest Long-Term Returns?”, Hendrik Bessembinder, October 2024 draft

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Aaron Chan