(Ri-Rf)t=alphai,t+βrm,t(RM-Rf)t + βsmb,tSMBt + βhml,tHMLt + βumd,tUMDt + єi,t
The issue of whether a manager is active or simulating activity in order to charge higher fees has been around for a while, not to mention whether both varieties produce results that justify those fees. Oddly, the first question is the harder to address: we know that by far the majority of managers, active or otherwise, woefully underperform their benchmarks after fees. Add to this how complicated it is to establish what counts for “activity” and you will be forgiven for wondering why do we still bother with the whole lot. (See this brief AAII Journal article, from which the above formula was taken; not exactly rocket science, but no easy-pickin’ for the un-initiated either.)
Recently we were blessed with two articles that touch on how to define active managers and, implicitly, what they should get paid. The first article indicates European regulators are piling-up on the matter with a vengeance (FT of February 15). While the discovery process moves along, consumer and investor protection groups are already requesting the disclosure of the names of the target fund managers: reminds me of the French revolution and how easily you could have ended up without a head. One of the dangers in all of this is that we risk to codify parameters which are not uniquely related or even useful to the task at hand, giving practitioners a clear way to rig the game in the future. Another is to make things so complicated no one will be better off for it: ultimately if the investor or client doesn’t get it what’s the use of the regulation?
Switching gears slightly, a group of managers usually thought of as activity personified, hedge funds, is under attack from a different animal. While regulators have yet to dream of the definition of active management in the area of alternative investments, the quants have rushed to fill the void. In the second article (FT of February 18) we are told that quants think hedge fund strategies can be replicated more economically with algorithms. This too is an old story which seems to be getting a second life (nothing works its magic better than a period of lackluster performance, and a mob of angry fee-paying investors). Someone quoted in the FT article gives us this pearl: “The hedge fund industry is bifurcating, between the ones that are truly active and those that merely generate alternative beta.” The implication is that alternative beta can be easily replicated – they are not called “quants” for nothing, maybe like the guy in the picture – and at a far cheaper cost than regular hedge fund fees.
All this fracas begs some questions. Buffett, is he an active investor or just a smart beta replicator (after all, he says he never sells)? Should compensation be related to the level of active risk or to the results obtained? How much should the compensation be? Is there skill in picking the right “factor” at the right time?
Told you. This will be tough.
Photo sources: https://www.sippclub.com/passive-index-funds/.