Improving Active Investment Performance
The beginning of the year is a natural time to assess investment success. Some strategies will have done better than others which will draw your attention, but adding to prior year’s winners comes with risks. How can you improve your chances of success within active management? Consider categorizing managers based on predictive versus participatory active management. We make the case that participatory should be a larger allocation based on improved risk, return and transparency.
First, let’s discuss the definition of what Relevance Wealth calls predictive and participatory active management. Predictive active management is when a manager weighs the probability of future events and positions their portfolio to benefit from enhanced relative performance. Types of bets a manager could adjust for are the rise or fall of interest rates, the relative performance of one security over another or the future performance of growth over value. Simply put, predictive active management is a form of market timing. A manager's educated guess could be right or wrong.
In contrast, participatory active management is where a manager creates value, through structuring bets based on visible market dislocations. How can one benefit from what is already known, wouldn’t any additional gains over the market be arbitraged by market participants quickly? Generally, the answer is yes, but there are several dislocations that occur over time that can provide above-average returns. Actions a manager could take include aggregating smaller securities into larger ones. Once a security is a reasonable size it attracts larger players which often lowers the spread of a security. In layman’s terms, let’s call it a bulk discount. Another example is the spread between illiquid or worse, private assets and public securities. If you had the experience to convert private assets to liquid securities the spread would drop as investors no longer struggle with the potential lack of transparency and zero trade volume for accurate price discovery. The illiquidity premium is alive and well.
The preference for daily liquidity versus illiquid assets and large versus small is reflected in the market where the yield premium on illiquid assets over liquid can range as high as 8-10% but is more typically 3–4%. Similarly, smaller-sized securities can’t always access the most efficient capital and can receive a yield premium like the above example. Combining the average premium for small and illiquid credit can add up to 6% or more, a huge advantage in today’s market. A participatory active manager could capitalize on these inefficiencies by aggregating several small assets and combining them into a larger one, get it rated and listing it. Either of these two actions could create above-average returns as the potential investor base would expand significantly providing greater competition for the security.
The efficient market hypothesis states that all asset prices fully reflect all available information. The larger and more liquid a market the fewer the dislocations and the greater the use of predictive active management. In smaller and less liquid parts of the market, there are varied forms of market friction that can provide advantages to those that have the knowledge, skills and tools to benefit from them. In these markets the use of participatory active management can be far more profitable and provide excess returns for those with a competitive advantage. To top it off, the alpha achieved from these bets can be activated by the manager providing less market directionality and smoother returns, perhaps something to think about while you are assessing your future strategy.