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CHAPTER 1 CHALLENGES TO ACTIVE INVESTING

      Creating positive alpha (risk-adjusted excess return) through active equity investing has always been hard, but it has been getting harder for today's investment managers with no clear end in sight. Spending the time and energy to investigate, analyze, and monitor companies for individual investments in the public markets takes dedication, curiosity, and experience. In the past, when done well, this work has paid off. It still can today, but the historic challenges were amplified in the 2010s and will continue in the 2020s.

      The focus of Part I will be to analyze the unique challenges that arose in the 2010s for active investment managers and consider how these challenges will continue to affect the 2020s. The confluence of two separate forces has pressured the key investment tenets that have historically led to outperforming the broad equity markets. Those two forces are massive central bank intervention (chapter 2) and the accelerated pace of technology (chapter 3).

      In Part II the focus will shift to an in-depth discussion of the key investment tenets and investment process necessary to outperform the public equity markets. I hope by intimately defining the keys to a successful investment process and recognizing the specific challenges in the execution of the process that managers may overcome and adapt to the challenges and produce superior returns (alpha).

Active investing alpha has been falling

Historically less than 50% of investment managers have succeeded in producing consistent long-term alpha for their clients. In recent years that number has been dwindling significantly, and overall alpha across the entire investment industry has been falling. The consequence is a significant trend of capital moving from active investment strategies to passive investment alternatives. Passive alternatives are exchange traded funds (ETFs) and other similar, highly diversified factor portfolios that exactly or nearly track benchmarks. Today, allocators are questioning the value of active investment management and re-embracing many of the efficient market hypothesis beliefs developed in the 1970s. Whether it be new automated security selection technologies or factor investing designed to manage capital on a diversified risk-adjusted basis, belief in the value of fundamental active management is waning.

      During my 87 years I have witnessed a whole succession of technological revolutions. But none of them has done away with the need for character in the individual or the ability to think.

       —Bernard Baruch, investor

      There are certainly situations in which passive investing is the best alternative. For most individual non-sophisticated investors, passive alternatives are clearly the best option. This book is geared toward professional investment managers and capital allocators interested in learning and honing the craft of active management. For this group of dedicated investment professionals alpha creation is very possible. One caveat is that alpha creation is harder in some markets than others and strategies must match expectations. Large cap investing in the US is a more difficult universe to create alpha in than small cap emerging market investing. Managers must understand both the potential and limits to their unique strategies and build their investment process on their investment goals.

There are many indices and specific methodologies by which to measure hedge fund alpha over time, and specific time periods have unique market issues, but the overall downward trend is undeniable. Figure 1.1 provides 30 years of hedge fund return data. The trend line is clear and the last decade demonstrates the pressures on the core investment tenets and decision-making that we will be discussing.

The result of the poor performance has been very poor net asset flows into hedge funds, which puts short-term pressure on hedge fund managers to perform well or risk having to close their firm. Figure 1.2 shows that it is clear that attracting capital for hedge funds has been very difficult during the 2010s. The ten years prior to the financial crisis saw a net $665 billion go into hedge funds. The financial crisis caused large outflows totaling $275 billion, which is not uncommon during times of stress. However, from 2010 to 2019, net inflows to hedge funds totaled only $105 billion. This is not only five times less than the ten-year period prior to the financial crisis but it is reclaiming less than half of the assets that were withdrawn during the crisis.

This is not an issue specific to hedge fund managers alone or an indictment of the hedge fund industry in any way. This is central to all active investment managers trying to outperform the market over the last decade. Not only has alpha been dropping, the percentage of managers who outperform at all has been dropping. Figure 1.3 demonstrates the drop in the percentage of active managers outperforming the S&P 500 on a five-year average return basis. Until the 2010s the percentage of managers outperforming was in the mid-to-high 40s, but since 2010, it has dropped to the low-30s range.

FIGURE 1.1 36-month rolling alpha of the HFRI Fund of Funds Composite Index

      Source: Hedge Fund Research (HFR).

FIGURE 1.2 Net asset flows into hedge funds

FIGURE 1.3 Percentage of US equity funds that beat the S&P 500 (five-year average)

The mutual fund industry is monitored separately, and the majority of mutual fund managers have underperformed their benchmarks

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