Happy 2018!! (Blows noisemaker.). POP! What’s that? The sound of the market bubble popping? The crypto bubble popping? (Confetti rains down). Ahh. Just the confetti popper thing. (Sigh of relief).
The first newsletter of this new year is brought to you by the letter “A”. As in “Active Management”, inspired by a real-life conversation with a JP Morgan salesperson last month.
First, a little background. Active management as a concept didn’t exist before the 1970's. All investing was “active” - you made choices about what stocks would perform best based on whatever you thought predicted performance and then bought them. Starting in the 70’s, but really gaining momentum in the 90’s and 2000’s, it became possible to invest in index funds (first with index mutual funds and then through ETFs - Exchange Traded Funds). Rather than try and pick a couple individual stocks, you could just invest in the entire index. This is considered “passive investing”, because you just buy all of the stocks together and get the aggregate performance of everything.
Tons of money have been flowing into these passive funds, both because they are cheap and because they have a 10+ year track record now of beating the vast majority of active mutual fund managers. (Literally tons of money. $1 trillion weighs about 11,000 tons in $100 bills, and passive funds have seen at least $4 trillion come their way in the last couple decades.) Active managers have mostly responded by freaking out and trying to make a lot of disparaging claims about how passive investing is the devil and how their own investing brilliance will be better for you in the long-term. And sure, for that brilliance you will have to pay a little more, but it’s for your own good.
There are two types of active management we find acceptable. One type of active management is the type that has always existed - doing the fundamental research to choose a select handful of stocks you feel will perform the best. We don’t think this type of active management has a great track record overall, but it is conceptually acceptable as a form of active management to pursue.
The second type of active management is at a more “macro” (big-picture) level. This is the kind of active management we employ here at ATI Wealth Partners. We use passive ETFs to create our portfolios, but then make decisions about how invested we will be in those ETFs on a spectrum ranging from 100% invested all the way down to 50% invested. Depending on market conditions, our strategy could be 100% stocks and 0% bonds, or 50% stocks and 50% bonds/cash, or anything in between. Active management of passive products, if you will, as opposed to a buy-and-hold approach.
There is another type of “active management” that gets peddled heavily these days that, in reality, is nothing more than a smokescreen to try and hide higher fees and irony.
Here’s what JP Morgan does. No, let’s not single out JP Morgan, because we guarantee you that every other big bank/asset manager out there does the exact same thing. Let’s use a theoretical financial management firm called...PJ Gorman. (NB: Please read all quoted passages for the remainder of this newsletter with as much irony as the voice inside your head can muster).
PJ Gorman has a series of “actively managed” portfolios with some flashy name like “PJ Gorman Select” or “PJ Gorman Managed Balanced Core” or something like that. There are probably 5 or so portfolios in this series - “Aggressive”, “Moderate”, “Balanced”, “Growth”, “Income” - and those portfolios will differ in the ratio of stocks to bonds. You’ll have an 80/20 portfolio (80% stocks, 20% bonds), a 60/40 portfolio (60% stocks, 40% bonds), a 50/50, a 40/60, and a 20/80. The one that you will get is based on some arbitrary risk score that is, in turn, based on a combination of your age and vague psychological theoretical questions you’ll have to answer. Not kidding.
So. Say your money goes into the “PJ Gorman Managed Select Moderate Growth Balanced Core” fund, which is a portfolio comprised of 60% stocks and 40% bonds. Except PJ Gorman is not selecting individual stocks and bonds to put into this portfolio; instead, they are selecting other active managers and putting those managers’ funds into your portfolio. You’ll be sold on how active management is better than passive management, how PJ Gorman has a team of the smartest people in the world, how that team gets together once a month or so to talk about investments, and how out of those conversations has put together the best possible portfolio for you that could ever exist. Not only that, but they promise to monitor it for you and make changes! Actively managing the active managers! And for the privilege of accessing their peerless investment prowess, they charge you somewhere between 1% and 2%. On top of the fees you’re paying to the underlying active managers.
Irony #1: Speaking of the underlying managers, the largest individual positions in the managed portfolios will likely be passive index funds. That’s right, passive. Why? Because PJ Gorman is terrified of the possibility of underperforming the broad market. So they try to basically get the same returns as the market, and then add a couple funds on the margin that will hopefully result in a little bit of outperformance for them. Or at least not hurt them too badly if they’re wrong.
Irony #2: PJ Gorman tries to justify their 1-2% fee by actively managing the active managers in the portfolio. So every month you’ll see that they sold a tiny little bit of one manager and bought a tiny little bit of some other manager. But the thing about those kind of managed portfolios is that they are usually completely static from a macro perspective. Ask your friendly salesperson at PJ Gorman what their risk budget is - how much can they deviate from that 60% stocks 40% bonds position - and the answer will usually be something like 5%. Maybe they could go up to 65/35 or down to 55/45. Great. (Blows sad, deflated noise maker).
We don’t care how active you are within your “PJ Gorman Managed Select Moderate Growth Balanced Core” 60/40 managed portfolio, you’re still a 60/40 portfolio. Market looks great? You’re 60/40. Market looks terrible? You’re 60/40. The fact that PJ Gorman’s “active management” caused their 60/40 portfolio to beat another firm’s 60/40 portfolio by 0.1% is a little bit like putting Guerlain lipstick on your pig and entering it in a beauty contest. A non-pig beauty contest.
Here’s another way to visualize what’s going on - think about market movements as weather patterns. PJ Gorman and friends have a very nice closet of long-sleeve shirts for your portfolio. All different colors, crew necks, v-necks, button-down, plain cotton, waffle print, Henleys, etc. You could dress your portfolio up in a different long-sleeve shirt every day of the year. Imagine the Instagram following it could have! But only long-sleeve shirts. What if the weather is beautiful and you want a short-sleeve tee - or a swimsuit? Or what if it turns cold and you need to reach for a jacket? Oh well. Hope that portfolio doesn’t get frostbite!
Let’s recap. PJ Gorman’s managed portfolios start by picking other managers who pick stocks to try and outperform the market. Except PJ Gorman doesn’t trust the ability of the managers they pick, so they make sure to include heavy allocations to passive index funds. And then they shuffle the deck chairs on their 60/40 Titanic to justify the fee they charge. We’d be willing to bet you could replicate 90% of the performance of those managed portfolios on your own with about 5 funds, and it would cost you less than a tenth of what the PJ Gormans charge, and you could do it in the time it takes to listen to an Alanis Morissette song. You know the one we’re talking about.
So if you like the idea of un-ironic active management, great! We’re right there with you. Give us a call.
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