Active vs Passive Management

Actively and passively managed products are available across many different investment products, but as AlphaWeek covers the alternative investment industry and I work within the hedge fund segment of this industry, I’ll be looking at hedge funds as the active management investment vehicle. I will also focus the majority of the article within the equity hedge fund section of the industry.

As an executive summary of my active and passive management investment philosophy, I believe in:

• Paying low, passive fees for market risk, and other known risk factor, exposures;
• Paying performance fees for exposure to Beta/systematic risk-neutral exposures, such as:
• (i) idiosyncratic risk;
• (ii) new/not well-known factor risk(s), and
• (iii) alpha generation.
• I don’t believe in paying performance/active management fees for a high mix of exposure to systematic risk and other risks. 

Figure 1: A breakdown of equity exposure vehicles and management types

Why is it difficult for active managers to consistently beat passive investment returns?

Active managers have two primary disadvantages, or hurdles, to get over in order to consistently beat passive returns. These two hurdles are the fund’s cash holding - which means less than 100% of active AUM is competing against 100% of passive AUM - and fees. How much do these hurdles affect parity, ceteris paribus?

To calculate an active manager’s return parity, I use the following assumptions: a traditional 10% of AUM cash position and a traditional hedge fund 2&20 fee model (2% management fee & 20% performance fee).  In order to calculate parity, I used the S&P 500’s 2019 monthly returns for both active and passive returns. I also assumed a 25 basis-point fee as the cost to get exposure to the S&P 500 via an Index or ETF, for example the SPY. I have also included a 1&15 model, as average hedge fund fees have fallen in recent years.

In 2019, hedge fund active managers with a 2&20 fee model needed to return an additional 55.44% on top of the passive investment’s gain in order to just break even on a net return basis versus the passive investment and those with a 1.5&15 fee structure needed 38.54% (see Figure 2 below). This, large, parity return needs to be earned every single year by the active managers just to break even. The two main tools that the hedge fund active managers have in order to make up this parity return are (1) the use of leverage - being able to use more than 100% of AUM, and (2) the ability to take on more types of risk than the passive investment strategy/product.

Source: Excel computation using the above return and fee assumptions

Market Theory Overview – EMH, CAPM, APT

At this stage, I think it's important to touch on the different market theories. In the 1960’s, Eugene Fama developed the Efficient Market Hypothesis (EMH) in his Ph.D. dissertation. The EMH essentially states that stock prices reflect all relevant information at all times and trade at exactly their fair value. This means that it is impossible to consistently beat the market and that choosing market-beating stocks is more about luck than judgement.

In 1964, William Sharpe developed the Capital Asset Pricing Model (CAPM). The CAPM is a single factor linear model that states that an asset’s expected return is equal to a combination of the factor of market risk to that asset and alpha.  

The Arbitrage Pricing Theory (APT) developed by Stephen Ross in 1976 was developed as an alternative to the CAPM. The APT is essentially a multi-factor pricing model based on the idea that an asset's returns can be predicted using the linear relationship between the asset’s expected return and a number of macroeconomic variables that capture systematic risk.

The primary differences between the APT and CAPM are that the CAPM is a single factor model (market risk) and assumes an efficient market. The APT is a multi-factor model but believes there are short-term price dislocations before finding their way back to fair value. 

The last model I want to reference is the Fama-French 3-factor model developed in 1992. Fama and French found that 3 different factors - the CAPM market factor, along with a size factor and value factor - better explains asset prices returns (this is a combination of CAPM and APT). 

These theories are widely taught and widely used within the investment arena. In my opinion, all of them have their pro’s and con’s but none of them do a great job of really explaining asset prices. This is primarily due to the math and assumptions that go into the models, which I will explain in more detail in future posts, as well as changing market ‘factor’ dynamics.

Systematic Risk, Idiosyncratic Risk, Factor Risk

I also want to touch on the well-known different types of risks. They are:

1. Systematic Risk/Market Risk

Macro factors that move the broad markets – APT has multiple factors (for example GDP, rates, unemployment) while CAPM has one. Systematic risk cannot be diversified away.

2. Unsystematic Risks/Idiosyncratic Risks

Unique risks to individual stocks (for example Governance, product line, financial fraud, loss of Directors). Idiosyncratic risk can be diversified away; as the number of stocks increase in your portfolio, the idiosyncratic risk tends towards zero.

3. Factor Risks

Fama & French found that value & size factors brought in risk-adjusted returns not driven by market risk. Carhart added a momentum factor to be a 4-factor model (1997) and Fama-French later developed a 5-Factor model (2013); Market, Size, Momentum, Profitability & Investment Patterns; Fama disagrees with Carhart’s momentum factor primarily in terms of its economic validity.

Passive & Active Management

My believe on investment into passive or active management is based on which type of risk(s) I want exposure to. I believe that low fees should be paid for systematic exposure, and other well-known factor exposures, in a passive management style, and active management/performance fees are only to be paid for concentration of both alpha and idiosyncratic exposures with low-no systematic exposure. That means, based on the following market theories:

- EMH

Systematic/Market Risk

I would invest in passive investments across all asset classes as all prices are always fair value.

Alpha

Within EMH, you cannot consistently beat the market and any market-beating strategies are just luck, therefore I would have no actively managed investments.

- CAPM

Systematic/Market Risk/Beta

I would invest in cheap, passive investments in the proxy of the market within each asset class.

Factor Risks

As CAPM only has one factor which is market risk above, there would be no investment in ‘other’ factors.

 Alpha

Using CAPM, alpha is explained as the excess return of the market. As I already have market exposure via my passive investments, I would use active investment in market-neutral/low to no beta strategies that bring in returns unrelated to my passive market returns therefore concentrating on pure alpha returns.

- APT

Systematic Risk/Beta

Similar to the CAPM, I would invest in cheap, passive investments in the proxy of the market within each asset class.

Factor Risks/Betas

1. I would have passive investment in the ‘cheap’ ETFs that exist bringing exposure to non-market factors like Fama-French’s 4 factors and Carhart’s momentum factor.
2. I would have active management in exposure to new or unknown factors, to the wider public, that are market-factor neutral.

Alpha

Using APT, alpha is explained as the excess return of the factors. As I’d already have factor exposures via my passive investments, I would use active management in market-neutral/low to no beta strategies that bring in returns unrelated to my passive market returns.

Overall, I would have the majority of my investments in low-cost passively managed market and factor exposures across the different asset classes with a smaller allocation to risks/exposures that can be provided by active managers, for example hedge funds, to help further diversify the portfolio and add to the portfolio’s return in terms of alpha. According to my investment philosophy, passive investment already covers equity market risk and as I don’t want a strong overlap in exposure with my active management investment, I would not consider equity hedge funds that are heavily exposed to market risk, i.e. have a significant beta coefficient. Another reason, I do not want my active investment to have the same exposures of my passive investments is due to the significant hurdles that was spoken about at the beginning of the article.  

In my next article, I will go into more detail on my specific hedge fund investment philosophy.

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Karl Rogers is Founder of ACE Capital Investments

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