BehavioralMattersInsights from the application of Behavioral Finance | Issue 41

BewarePassive

InvestingBy: Michael A. Ervolini, CEO

February 28, 2017

INTRODUCTION

Active management is tough business. Once alpha-generating strategies can lose their luster in a

quarter or two, helping to explain why 4/5 of active funds underperform each year. The challenges

facing active management — particularly the competitive threat of passive products — have never been

greater. In response, traditional investment management companies have launched a host of initiatives

to fortify their businesses including: creating custom portfolios to match unique client requirements,

establishing their own index and ETF offerings and revamping marketing/customer relationship services.

Less frequently observed are concerted efforts directed at improving skills, processes and ultimately

performance: not improvement as an aspirational goal as it is generally approached, but improving

deliberately using rigorous feedback and a scientific method. This essay takes a hard-nosed look at the

pummeling being taken by active management and argues that improving can no longer be approached

passively and that it must become a core competency for every active manager.

“Nobody is going to save you but yourself and the best and only way to do so

is through action.”

- Oli Anderson

Behavioral Matters is a series of essays on the application of Behavioral Finance written specifically for professional investors and portfolio managers.

© 2017 CABOT INVESTMENT TECHNOLOGY, INC. // BEWARE PASSIVE INVESTING: ISSUE 41 | 2

TSUNAMI

The global shift in assets away from active to passive products, while already substantial, is about to hit

its full stride, according to Moody’s Investor Services. In a recent report, they state: “Passive investments

– ETFs and index funds – account for $6 trillion of global assets. Now 28.5% of assets under

management (AUM) in the US, their US market share is rapidly expanding, driven by lower cost and

better performance relative to actively managed funds.” Moody’s goes on to project that within the U.S.

passively managed assets will exceed those actively managed sometime between 2021 and 2024. They

further estimate that between 5%-15% of assets in Europe and Asia are managed passively today but

expect this proportion to grow significantly in the near-term.

Moody’s believes this capital reallocation reflects, in large part, investors reassessing their options: "The

main driver of flows out of active funds into passive funds has been investors' growing awareness that,

by definition, actively managed investments, in aggregate, cannot deliver above average performance,

and that investing is therefore a zero-sum game – for every winner, there must be a loser(s).” An

additional driver cited is changing regulations: “Passive investments' expansion has been further

supported by global financial regulation, which has encouraged greater disclosures of fund fees and

potential conflicts of interest.” The report adds: “In practice, it will become more difficult for advisors to

place their clients into higher cost and more complex investment products.” All of which will impact

asset aggregation the report concludes: “Selling low-fee index products, on the other hand, will eliminate

many apparent conflicts of interests and minimize an advisor’s fiduciary risk.”

“Within the U.S. passively managed assets will exceed those actively managed

sometime between 2021 and 2024.”

“

© 2017 CABOT INVESTMENT TECHNOLOGY, INC. // BEWARE PASSIVE INVESTING: ISSUE 41 | 3

Active management is ill equipped to achieve meaningful

improvement currently due to the heavy dependence upon

folklore and poor feedback to support learning. Expressions of

folklore recited routinely include: it is a good sell as long as the

proceeds are reinvested in a winning buy; growth managers are

more likely to exhibit the endowment effect; and managers that

beat their benchmarks do so primarily by purchasing great

names. Comforting as these and other investment truisms feel

they are often wrong, as borne out by Cabot’s analysis of more

than $2 trillion of professionally managed assets.3 Reliance on

such pseudo-facts gives individuals a false sense of their own

strengths and shortcomings, making it near-impossible to

improve.

Poor feedback is what inhibits self-awareness and improving.

What type of feedback specifically? All of it! Conventional metrics

such as: relative return, information ratio, tracking error, alpha,

attribution analysis and hit rates are merely scorecards. They

provide useful information about past performance yet they say

nothing about the manager’s strengths and weaknesses.4 Most

importantly, they cannot guide the manager to the one thing she

should do today to become a better investor tomorrow.

Improving requires facts not hunches, and needs to be driven by

rigorous analytics not emotionally laden recollections or reliance

on comforting narratives.

STRUCTURAL SHORTCOMINGS

IMAGE HERE

“Reliance on pseudo-facts

gives individuals a false sense of

their own strengths and

shortcomings.”

© 2017 CABOT INVESTMENT TECHNOLOGY, INC. // BEWARE PASSIVE INVESTING: ISSUE 41 | 4

How do you generate most of your portfolio’s performance, from buying or selling? The answer

probably came to you before you finished reading the prior sentence. But how do you know? You can’t,

not for sure. Knowing implies the availability of data-driven facts such as: my buying generates over 175

basis points of relative return annually while my selling, which used to cost the portfolio 225 basis

points, is now neutral. Lacking rigorous feedback like this you’re just guessing. And as the Moody’s

report makes clear — guessing ain’t getting it done.

Fortunately, a new analytic framework that supports learning and improving now exists. The new

framework enables you to quantify skills, processes and behavioral tendencies. Armed with this clear

feedback you can set about becoming self-aware and improving deliberately. This framework is being

used by hundreds of professional investors around the globe and the results are impressive. Portfolios

engaged in deliberate improvement are, on average, adding approximately 45 basis points of

incremental relative return year after year.5 These managers are using their processes to do more of

what they do well, to improve where needed, and to eliminate unproductive behavioral tendencies.

The analytic framework and how it supports improving are fully described in: “Managing Equity

Portfolios: A Behavioral Approach To Improving Skills and Investment Processes,” by Michael Ervolini,

MIT Press. Mike’s book also includes seven ideas or projects that will allow you to begin improving

deliberately right now.

NUMBERS YOU CAN COUNT ON

“Portfolios engaged in deliberate improvement, on average, add

approximately 45 basis points of incremental return year after year.”

“

© 2017 CABOT INVESTMENT TECHNOLOGY, INC. // BEWARE PASSIVE INVESTING: ISSUE 41 | 5

CONCLUSION

© 2017 CABOT INVESTMENT TECHNOLOGY, INC. // BEWARE PASSIVE INVESTING: ISSUE 41 | 6

ENDNOTES1. Anderson, Oli, “Personal Revolutions: A Short Course in Realness,” CreateSpace Publishing, 2016.

2. Moody’s Investor Services, “PassiveMarket Share to Overtake Active in the US No Later than 2024,” February 2, 2017.

3. Buying and selling should, in fact, be evaluated separately which leads to a good sell being one where the position sold goes on to

underperform the manager’s portfolio. The endowment effect or holding onto winners too long is found in every type of portfolio

(i.e., growth, value, core, benchmark agnostic, etc.). Many successful managers derive most if not all their excess return from

strong selling and/or position sizing, often in conjunction with neutral or negative buy skills.

4. A more expansive discussion on this topic can be found in Chapter 2 of “Managing Equity Portfolios, A Behavioral Approach to

Improving Skills and Investment Processes,” by Michael A. Ervolini, MIT Press, 2014.

5. Based on a study of over 80 professionally managed portfolios across a five-year timeframe. For more information see:

“Improving Deliberately”

Passive investing is now hitting its stride and soon will be lapping

active management in the US and the same is expected throughout

Europe and Asia in the not-too-distant future. As Moody’s explains

it: “Investors will continue to shift to beta investments, whether

smart, simple or exotic, given their lower costs, better performance

and transparency.” In light of this assessment, approaching

business as usual will, for a number of management companies,

likely segue into “out of business.”

In contrast to the troublesome asset reallocation occurring,

improving how well you invest is completely within your control.

There is plenty of evidence to suggest that if you approach

improving passively you are all but doomed to deliver passive

results, or less. There is no sensible argument for not wanting to do

your best for your clients and that can be achieved only through

deliberate improvement. Of course, actively engaging in deliberate

improvement may not assure you a place on “the stairway to

heaven” but taking a passive approach to becoming a better

investor will surely result in a terminal case of the “Moodyblues.”

INSERT IMAGE HERE

Cabot helps equity portfolio managers and

research analysts improve. Using our

proprietary patented analytics we help

investment professionals better understand

their skills, investment processes and

behavioral tendencies. Clients then collaborate

with Cabot to implement pinpoint refinements

to the way they buy, sell and size assets.

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www.cabotintech.com

READY TO IMPROVE DELIBERATELY?

CONTACT CABOT

Improvement of more than 150 basis points of incremental performance is typical

among clients during their initial three years of Cabot collaboration. In addition to

generating stronger results, these investment professionals gain deeper self-

awareness, streamline their investment processes and build stronger relationships

with their investor-clients aided by compelling charts, graphs and other

communication tools. Knowing is better than believing – if your goal is to do your

best today while learning and improving for tomorrow, then we’re here to help.

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