Thoughts on Manager Process, Man v Machine, & Alpha vs Beta

Editors note — No coverage of IEX marketing practices today…  

In Manager Selection, Process Should Matter

Thanks to TabbForum for posting my latest commentary, an in-depth explanation of why the dominant trading strategy used by active money managers creates a major drag on their performance.  I hope that the FCA and the EU regulators get a chance to read it, as they prepare their case against the pension consulting industry.  I say this since, according to many people in the industry I have asked, those consultants do not examine the trading process of the managers they recommend.  To my mind, that is malfeasance for a fiduciary, whose job it is to predict the sustainability of manager returns…

Garbage in, Garbage out…

Excellent article in the WSJ that examines some of the hype surrounding AI, machine learning and model based trading.  The key point, that the biggest danger in such models is over-fitting, is very true.  They explain this well by making the point that limiting models to only recent history can create enormous biases.  This proves that the old adage in computer science “garbage in, garbage out” is still true.   That said, there is little doubt that computer models can predict asset price movements in many cases.  The best funds work hard to include human intuition in their process, however, whether by insisting on “explainable” models based on logical factor relationships or by using models to augment human intelligence.  While the market is far more complex than a game of chess, the fact that human players, with access to computer programs easily beat advanced chess computers, is illustrative of the potential for machine augmented intelligence.

More Confusion on Man vs Machine

CNBC wrote about man vs machine and claimed that recently, systematic strategies were inferior to human beings on stock picking.  While that is possible, I suspect they are confusing “stock picking” with macro investing, which is where Hedge Fund managers engage in both market timing and relative performance among asset classes and geographies.   Simply put, they are likely confusing stock picking, which is the pursuit of “alpha” (individual asset out-performance) with making bets on “beta” which is betting on the returns of an asset class or sub-class (such as large cap vs small cap or growth vs value in equities, “bets” on the relative returns of currencies or of the debt of different countries, or on changes in the yield curve or relative yields across the credit spectrum, etc.).  I make this point because many asset managers make such “bets” on beta despite being paid to pick stocks or bonds relative to a specific benchmark.  Considering that those activities earn very different fees (and incur very different costs), it is important to know the difference.

Will RIAs be good or bad for the largest financial firms?

Bloomberg published an article that calls for the death of wirehouses, the same day after CNBC points out how Wealth management is increasingly important to banks….  While I have no opinion on what type of FIRM will win, the big winners could be investors.   The type of portfolios that used to be the exclusive province of large institutional asset managers can now be delivered by an individual advisor with an account at almost any firm.  This has been facilitated both by advances in technology and the development of ETFs, which offer such a broad range of diversified, low cost portfolios tracking almost every asset class, industry, or factor, that an individual can efficiently construct well diversified portfolios for almost all individual investors.  While there are many arguments about how smart, so-called “smart beta” strategies are (For the record, I think most are pretty basic and inappropriate for a static, long term investment), there is no doubt that these ETFs provide investment advisors the opportunity for building better diversified portfolios.

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