The scientific side of the active/passive debate

David SchofieldThe recent decision by Norway’s SWF and some large US pension funds to explore their active management allocations, reported last week by, reflects the re-ignition of the age-old active versus passive debate. But according to the scientifically-based INTECH, if maths prevails, it is an argument that is dead in the water. Amanda White spoke to president of the international division, David Schofield.

Now that the severe market turmoil seems to be over, some more interesting deliberations are re-emerging in its wake.

The events of 2008 caused such a shock that a lot of investors have reacted in one of two ways: a re-examination of their allocation to equities; or a re-assessment of the validity of active management.

But according to the mathematicians at INTECH, who sit firmly on one side of the fence, the reassessment of active management is a knee-jerk reaction to a short-term phenomenon.

Instead, they argue the theoretical support for passive management is weak, and further that active allocations should be taken where the majority of an institutional investors’ portfolio is exposed, in large cap equities.

President of the international division of INTECH, David Schofield, says passive management seems safe but investors are not fully considering the risks involved.

“Passive management still contains market risk which is the large risk compared with the incremental risks in active management,” he says. “The academic argument that the average active manager underperforms is just a truism, passive managers will also be behind the market because of fees. That the market portfolio is an efficient portfolio is a very weak argument; it is based on a whole raft of assumptions that are not true in the real world.”

According to Schofield, the assumptions that underlie the market portfolio are flawed, with the capital asset pricing model based on assumptions like: all investors have the same time horizon, all investors share the same opinion of stocks and asset classes; you can borrow an unlimited amount at the risk free rate; and there is assumed to be no costs with short selling.

INTECH Investment Management is in a fairly good position to question the validity of the passive academic argument, having based an entire business on academic research, and a theorem developed by its chief investment officer, Robert Fernholz.

The difference between this asset management firm and many others is its corridors are filled with mathematicians, and its philosophy is based in mathematics.

The process centres on a mathematical theorem that attempts to capitalise on the random nature of stock price movements stemming from Fernolz’s research published in its paper, “Stochastic Portfolio Theory and Stock Market Equilibrium.”

‘We strongly believe there is no theoretical impediment to investing, you can get outperformance,” Schofield says.

The research revealed the long-term effect of volatility on performance, with INTECH engineering an investment process that targets a specific return by controlling volatility.

“Volatility is a drag on long-term returns and shouldn’t just be thought of as a risk measure. The relationship
between volatility and long-term returns came out of that work, and if you reduce volatility you can enhance long term returns. We’ve engineered it into an investment proces – by controlling volatility we can target a specific return, so by doing XYZ there is a high degree of confidence we will outperform by X%.”

Identifying good managers has always been challenging, and particularly lately it has been difficult to assess whether alpha has come from skill or market movement.

But according to Schofield there has been far too much attention paid to performance, and not enough attention to process.

“If a manager has a credible process over the long term, there is an extremely high likelihood the manager will perform better than the market over time. We have quantified that, it is a mathematical proof,” he says. “And maths is the only area where you get absolutes, where you get proofs.”

With this in mind Schofield believes more due diligence should be put into the selection of funds managers in all asset classes, not just those that are less researched.

In fact INTECH argues a case for active management in large cap markets where investors have a large allocation, an area that is typically indexed.

“Most big investors by definition have most of their money in large cap big developed markets, an extra 1 to 2 per cent on a big part of the portfolio will have a larger effect on the total portfolio than 5-10 per cent on an esoteric asset class that’s also high in due diligence, often illiquid and has constrained capacity,” he says. “My view is if you can squeeze more from large cap core equity holdings that is more beneficial to the overall fund.”

This is especially true, he says, when markets are only returning 7 or 8 per cent.

With this in mind, the argument continues, more due diligence should be put in to the manager selection within large cap developed markets.

“There is far too little time spent on the process of the managers; people are too distracted by the focus on performance,” he says. “Active management is a very valid proposition if you can find a manager with a good process. Investors should look at the relationship between information ratio and outperformance, the closer the
information ratio is to one the higher the likelihood of outperformance over 10 years.

Our process hasn’t changed for 20 years, it doesn’t have to because its not dependent on what we think of markets. It’s a maths theorem, a proof.”