WEBVTT -  Bl’s David Cohne on Lessons From Active Managers

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<v Speaker 1>Welcome to Inside Active, a podcast about active managers that

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<v Speaker 1>goes beyond soundbites and headlines and looks deeper into their processes, challenges,

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<v Speaker 1>and philosophies in security selection. I'm David Cohn. I lead

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<v Speaker 1>mutual fund and active research at Bloomberg Intelligence. So we're

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<v Speaker 1>doing something a little different on the podcast this week.

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<v Speaker 1>Usually I'm joined by a portfolio manager or someone else

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<v Speaker 1>from the industry, but after spending the past couple of

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<v Speaker 1>years talking with active managers on the podcast about how

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<v Speaker 1>they invest, I thought it would be interesting to take

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<v Speaker 1>a step back and talk about some of the things

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<v Speaker 1>I've learned from those conversations and also how they line

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<v Speaker 1>up with what I'm seeing in my own research. One

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<v Speaker 1>of the reasons I started this podcast was that there

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<v Speaker 1>was a lot we can learn about a fund from

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<v Speaker 1>the numbers. We can look at performance, holdings, fees, risk,

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<v Speaker 1>factor exposure, and flows. But those numbers don't necessarily tell

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<v Speaker 1>us why a manager owns what they own, what they

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<v Speaker 1>think their edge is, or whether that edge has a

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<v Speaker 1>reasonable chance of persisting. That's what I've tried to understand

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<v Speaker 1>through these conversations. And after talking with managers who invest

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<v Speaker 1>very differently from one another, I found myself coming back

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<v Speaker 1>to a few questions. How do you distinguish a repeatable

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<v Speaker 1>investment process from one that has simply benefited from the

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<v Speaker 1>right market environment? How much can past performance really tell

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<v Speaker 1>us about manager skill? What should we look for when

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<v Speaker 1>we're trying to determine whether an active manager actually has

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<v Speaker 1>an edge? And maybe most importantly, what does it even

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<v Speaker 1>mean to say that active management works? So I thought

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<v Speaker 1>I'd spend some time talking through those questions, starting with

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<v Speaker 1>investment process. If you listen to enough portfolio managers, you'll

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<v Speaker 1>hear certain words quite a bit. Long-term, quality, competitive advantage, management, valuation, discipline.

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<v Speaker 1>And none of those things are bad. In fact, they're

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<v Speaker 1>all important. But one thing I've learned from doing these

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<v Speaker 1>interviews is that the description of an investment philosophy is

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<v Speaker 1>usually much less interesting than what happens when you start

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<v Speaker 1>pushing on how that philosophy is actually implemented. Take long-term investing.

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<v Speaker 1>Almost every active manager would probably tell you they're a

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<v Speaker 1>long-term investor, but that can mean very different things. For

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<v Speaker 1>one manager, it might mean identifying a company that can

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<v Speaker 1>compound earnings for a that looks expensive today. For another,

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<v Speaker 1>it might mean buying an asset at a substantial discount

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<v Speaker 1>to what they believe it's worth and being willing to

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<v Speaker 1>wait years for that value to be recognized. And for another,

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<v Speaker 1>it might mean accepting periods of significant underperformance because their

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<v Speaker 1>investment horizon is much longer than the market's. Those are

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<v Speaker 1>all very different approaches. So saying you're a long-term investor

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<v Speaker 1>doesn't really tell me very much. What I increasingly wanted

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<v Speaker 1>to know is what happens when things don't go according

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<v Speaker 1>to plan? What would cause you to change your mind?

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<v Speaker 1>What information would tell you that your original thesis was

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<v Speaker 1>wrong rather than simply early? And what would actually make

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<v Speaker 1>you sell? I probably become more interested in sell discipline

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<v Speaker 1>as I've done more of these interviews. It's Now, relatively

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<v Speaker 1>easy to tell a compelling story about why you bought

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<v Speaker 1>a company. The company has a large addressable market. It

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<v Speaker 1>has strong management. It has competitive advantage. Earnings can compound

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<v Speaker 1>for years. But what happens after you own it? Suppose

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<v Speaker 1>the stock rises much faster than the underlying business. Does

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<v Speaker 1>valuation eventually matter enough to sell? Suppose the stock falls 30%.

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<v Speaker 1>Is that an opportunity to buy more because a thesis

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<v Speaker 1>hasn't changed? Or is the market telling you something you missed?

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<v Speaker 1>Suppose the company is executing reasonably well, but another idea

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<v Speaker 1>now has a much better risk and reward profile. Do

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<v Speaker 1>you sell a company you still like? Those decisions tell

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<v Speaker 1>you a lot about how process actually works. And they

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<v Speaker 1>also get at something else I've been thinking about quite

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<v Speaker 1>a bit. The difference between having a good investment process

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<v Speaker 1>and having a market environment that happens to reward that process.

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<v Speaker 1>This has come up in some research I did on

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<v Speaker 1>large growth managers. Growth has obviously been a difficult place

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<v Speaker 1>for active management at different points in this market cycle,

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<v Speaker 1>particularly with returns concentrated in a relatively small number of

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<v Speaker 1>very large companies. When I looked more closely at the

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<v Speaker 1>funds that were succeeding, one characteristic stood out, momentum. Among

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<v Speaker 1>large cap growth funds with more momentum exposure than the

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<v Speaker 1>S &amp; P 500 growth index, 56% beat the index.

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<v Speaker 1>And when I weighed those results by assets, the success

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<v Speaker 1>rate was 84 among the funds with negative momentum exposure, 0B. Now,

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<v Speaker 1>I don't think the conclusion from that is that managers

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<v Speaker 1>should simply buy whatever has the most momentum. The more

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<v Speaker 1>interesting question is what those results tell us about how

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<v Speaker 1>we evaluate active management. Imagine a manager has a consistent

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<v Speaker 1>process that tends to lead them toward companies with strong

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<v Speaker 1>earnings growth and strong price momentum. Then the market enters

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<v Speaker 1>an environment when those characteristics are heavily rewarded and the

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<v Speaker 1>manager substantially outperforms. Was that skill? Was it factor exposure?

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<v Speaker 1>Was it the market environment? The answer may actually be

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<v Speaker 1>all three, and that's where evaluating active management gets difficult.

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<v Speaker 1>Michael Ervolini came on Inside Active earlier this year to

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<v Speaker 1>talk about skill versus luck, and that's a question that

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<v Speaker 1>has stayed with me. We tend to use performance as

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<v Speaker 1>evidence of skill because performance is so observable. But the

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<v Speaker 1>outcome and the quality of the decision aren't necessarily the

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<v Speaker 1>same thing. A good investment decision can produce a bad outcome,

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<v Speaker 1>and a bad investment decision can produce a good outcome.

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<v Speaker 1>And over short periods, it can be extremely difficult to

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<v Speaker 1>separate the two. That's why I think understanding the process matters.

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<v Speaker 1>But there's actually another side to this. A process can

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<v Speaker 1>sound incredibly compelling in an interview, yet still fail to

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<v Speaker 1>produce good investment results. Every manager can explain why their

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<v Speaker 1>approach should work. Ultimately, it has to work. So we're

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<v Speaker 1>consistently trying to reconnect those two things, the process and

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<v Speaker 1>the outcome. And some of my research has produced results

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<v Speaker 1>that have challenged assumptions about where active management should have

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<v Speaker 1>an advantage. One example is fund size. That's a fairly

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<v Speaker 1>intuitive argument for why smaller funds should have an advantage.

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<v Speaker 1>They can be more nimble. They can invest in smaller

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<v Speaker 1>companies without worrying as much about liquidity or capacity. A

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<v Speaker 1>position doesn't have to be enormous to make a difference

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<v Speaker 1>to overall fund performance. A really large fund, a fund

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<v Speaker 1>with a lot of assets, doesn't necessarily have those same advantages.

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<v Speaker 1>But when I looked at fund size and performance, that's

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<v Speaker 1>actually not what I found. Funds with less than $ 500

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<v Speaker 1>million in assets only had a 6.4% beat rate across

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<v Speaker 1>the periods I studied. And generally, success increased with the

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<v Speaker 1>amount of assets the fund held. I found it fascinating

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<v Speaker 1>because it raises a chicken and egg problem. Are larger

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<v Speaker 1>funds more successful because scale provides advantages? A larger fund

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<v Speaker 1>company may have more analysts, better access to management teams,

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<v Speaker 1>and more resources devoted towards research, risk management, and trading.

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<v Speaker 1>But maybe those funds are large because they were successful

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<v Speaker 1>in the first place. Investors rewarded good managers with assets,

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<v Speaker 1>so by the time we're measuring them, SARS may partly

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<v Speaker 1>be evidence of previous success. And then there's another question.

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<v Speaker 1>At what point does a scale that may reflect past

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<v Speaker 1>success start making future success harder? I don't think there's

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<v Speaker 1>one answer. It probably depends enormously on what a manager owns.

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<v Speaker 1>A large-cap manager running billions of dollars faces a very

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<v Speaker 1>different capacity constraint than a small-cap manager running the same amount.

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<v Speaker 1>But it illustrates why simple rules about active management can

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<v Speaker 1>be misleading. Small funds aren't necessarily better because they're nimble,

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<v Speaker 1>and large funds aren't necessarily better because they have more resources.

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<v Speaker 1>you have to understand what a manager is actually trying

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<v Speaker 1>to do. There's another assumption about active management that I've

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<v Speaker 1>been questioning through my research. We often hear a statistic

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<v Speaker 1>along the lines of only a certain percentage of active

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<v Speaker 1>funds beat their benchmarks. Now that's useful information. I use

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<v Speaker 1>that myself, but there's something important hidden inside that calculation.

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<v Speaker 1>If we're simply counting funds, $ 100 million fund and $ 100

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<v Speaker 1>billion fund each count exactly once. That's not how investors

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<v Speaker 1>experience the market. So I've increasingly been looking at performance

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<v Speaker 1>on an asset-weighted basis as well. And in a number

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<v Speaker 1>of categories, I found that the percentage of investor assets

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<v Speaker 1>outperforming can actually be considerably higher than the percentage of

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<v Speaker 1>funds outperforming. That doesn't make the traditional success rate wrong.

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<v Speaker 1>It's answering a different question. See, one asks what percentage

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<v Speaker 1>of managers succeeded. And the other is asking what percentage

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<v Speaker 1>of the money invested with those managers experience success. And

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<v Speaker 1>I think you actually need both. Because if 30% of

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<v Speaker 1>funds beat their benchmark, but those funds hold 60% of

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<v Speaker 1>the assets, the conclusion that 70% of active investors field

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<v Speaker 1>isn't really accurate. And it also raises another interesting question

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<v Speaker 1>about manager selection. We often talk about active management as

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<v Speaker 1>though investors randomly select a fund from the universe. They

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<v Speaker 1>obviously don't. assets tend to concentrate in certain managers and

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<v Speaker 1>in certain firms, that doesn't mean investors are always good

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<v Speaker 1>at selecting managers. They're not. And past performance can attract

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<v Speaker 1>assets at exactly the wrong time. But it does mean

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<v Speaker 1>the experience of the average invested dollar can look different

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<v Speaker 1>from the experience of the average fund. And that brings

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<v Speaker 1>me to what may be the biggest problem with the

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<v Speaker 1>active versus passive debate. We tend to ask whether active

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<v Speaker 1>management works as though active management were one strategy. It isn't.

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<v Speaker 1>Think about how the different managers I've had on this

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<v Speaker 1>podcast are. We've talked to managers investing in large cap growth, value,

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<v Speaker 1>emerging markets, small and mid cap stocks, global equities, corporate bonds,

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<v Speaker 1>securitized credit, and a few other areas. The opportunity set

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<v Speaker 1>is different. The benchmark is different. Market efficiency is different.

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<v Speaker 1>And the tools available to the managers are different. And

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<v Speaker 1>so the results tend to be different. And one of

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<v Speaker 1>the most striking examples from my research has been global bonds.

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<v Speaker 1>Over the 10 year period I studied, 96% of active

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<v Speaker 1>global aggregate bond funds beat the Bloomberg Multiverse Index. Compare

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<v Speaker 1>that with some areas of the equity market where a

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<v Speaker 1>relatively small minority of active managers have beaten their benchmarks

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<v Speaker 1>over long periods of time. Those aren't small differences. And

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<v Speaker 1>I don't think the right conclusion is simply that active

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<v Speaker 1>bond managers are good and active equity managers are bad.

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<v Speaker 1>I think the more useful question is why the opportunity

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<v Speaker 1>for active management appears to be so different. A bond

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<v Speaker 1>index isn't constructed like an equity index. Issuers that borrow

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<v Speaker 1>more money can become larger weights on a bond benchmark.

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<v Speaker 1>Managers can make decisions about duration, credit, sectors, currencies, and

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<v Speaker 1>positioning along the yield curve. The benchmark itself can create

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<v Speaker 1>opportunities and constraints that are very different from an equity benchmark.

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<v Speaker 1>That's one reason I've become increasingly skeptical whenever I hear

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<v Speaker 1>someone make a blanket statement that active management works or

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<v Speaker 1>active management doesn't work. My response is active management where?

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<v Speaker 1>What kind of manager? Against what benchmark? Over what period?

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<v Speaker 1>And what exactly are we defining as success? Those questions matter.

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<v Speaker 1>And I think that's probably the biggest thing I've taken

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<v Speaker 1>away from doing this podcast along with my research. The

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<v Speaker 1>numbers and the conversations are really answering different questions. My

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<v Speaker 1>research can tell me which managers beat, how much they

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<v Speaker 1>beat by, what characteristic the winners had. how much risk

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<v Speaker 1>they took, and whether investors actually benefited. But it can't

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<v Speaker 1>necessarily tell me why a manager made a particular decision.

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<v Speaker 1>And that's where talking to managers becomes useful. At the

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<v Speaker 1>same time, listening to a manager describe a thoughtful, disciplined

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<v Speaker 1>investment process can't tell me whether that process actually creates value.

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<v Speaker 1>That's where the numbers matter. You need both. And if

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<v Speaker 1>I were trying to identify an active manager today, I

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<v Speaker 1>don't think I'd start by asking whether they beat the

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<v Speaker 1>benchmark last year. I'd want to understand what they're actually

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<v Speaker 1>trying to exploit. Why should this opportunity exist? Why should

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<v Speaker 1>this particular management be able to take advantage of it?

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<v Speaker 1>What does their portfolio look like when their process is working?

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<v Speaker 1>And what does it look like when it's not? How

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<v Speaker 1>do they know when they're wrong? And then I'd go

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<v Speaker 1>back to the numbers and ask whether the evidence is

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<v Speaker 1>consistent with the story they're telling me, not whether they

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<v Speaker 1>outperform every year. No credible investment or active investment process

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<v Speaker 1>is going to do that. But if a manager tells

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<v Speaker 1>me their advantage comes from protecting capital when markets fall,

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<v Speaker 1>I should be able to see some evidence of that.

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<v Speaker 1>If they tell me they're willing to look different from

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<v Speaker 1>the benchmark, I should be able to see that in

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<v Speaker 1>the portfolio. And if they tell me valuation is central

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<v Speaker 1>to their process, their holdings and trading decisions should reflect that.

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<v Speaker 1>And if they tell me their edge is long-term investing,

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<v Speaker 1>I want to understand what they actually do when the

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<v Speaker 1>market tests that patience. That's really what I've been trying

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<v Speaker 1>to get at with Inside Active. Not simply whether active

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<v Speaker 1>management works, but how it works, where it works, why

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<v Speaker 1>it might work, and how we can distinguish a repeatable

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<v Speaker 1>investment process from a good story attached to good performance.

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<v Speaker 1>We'll get back to our regular conversations with portfolio managers

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<v Speaker 1>and other industry guests on the next few episodes. But

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<v Speaker 1>I just want to thank you for listening to Inside Active.

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<v Speaker 1>If you liked the episode, please share it, subscribe, and

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<v Speaker 1>leave a review. And if you'd like to see more

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<v Speaker 1>of our research on the terminal, go to BIFundGo for U.S.

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<v Speaker 1>fund and active research. Until our next episode, this is

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<v Speaker 1>David Cohn with Inside Active.