As previously broken down in our article How We Invest, we’re building a modern investment manager for the world of tomorrow. And one of the three key pillars of the proposition we’re building is actively managed portfolios.

We thought we should share more about our views on active management and lift the lid on our investment philosophy.

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What is ‘Active Investing’?

There isn’t always agreement on exactly where the line lies between passive and active investing. At Sidekick we like to make sure everyone is on the same page, so let’s start with a few definitions…. 

• If you are trying to beat some sort of benchmark by being different from it, you’re an active investor.
• If you just want to match some broad benchmark performance as closely as possible by paying the lowest possible fees, you are a passive investor.

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How might active investing add value over long time horizons?

Exploit Market Inefficiencies

Passive investors generally assume the market is informationally efficient, all participants are rational and there is no ‘edge’ to be exploited. At Sidekick we believe the market is very efficient most of the time. But, from time to time, emotional biases like fear or greed, and informational failures cause market values to depart materially from fundamentals. Active managers can take advantage of these situations.

Smart Capital Allocation

Passive indices normally invest in companies in proportion to their size. This means that passive investors allocate the most capital to the largest companies, not necessarily those with the highest future expected returns. The largest companies got large because they did well in the past. We have all seen the investment disclaimer: "Past performance is no guarantee of future results". This also holds true for companies. In our opinion, disregarding the future prospects of an investment represents a potential misallocation of capital that can lead to suboptimal investment outcomes. Active managers are typically focussed on what companies are going to do tomorrow. Not what they did yesterday.

Focus on Responsible Investing

To promote their views on responsible investing, active managers often engage directly with companies on sustainability issues. If business practices are not sustainable or a company is engaged in unethical and/or controversial business practices, active managers have the option to invest in something else. Passive investors generally do not analyse individual companies in the same way. They simply invest in the index.

Conviction in Best Ideas

If you invest in an index tracker you’re just along for the ride. Active investors have the ability to allocate more capital to their highest conviction ideas in an effort to improve risk-adjusted returns.

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Addressing the elephant in the room… 

On average, active managers underperform…

Before we dig into this section we would like to make one thing clear from the start. We don’t want you to walk away after having read our views on active management feeling like there is a right and a wrong answer. Active investment management isn’t a religion that requires blind faith. You don’t have to choose active or passive. 

It’s indisputable. The data shows that, on average, active managers underperform their benchmarks[1]. But let's take a moment to unpick that statement. The data doesn’t show all active managers underperform all of the time or no active managers have outperformed over long time horizons. 

In 1991, the Nobel prize winner William Sharpe, wrote an article titled “The Arithmetic of Active Management”. In it he said that the average manager will perform in-line with the market. Before fees. Thus, after you deduct fees, the active manager must underperform the market[2]. On average. Warren Buffet, despite being one of the most well-known and respected active portfolio managers, shares the same view. [3].

Following an evidence based philosophy, we agree with the empirical data. The average active manager will likely underperform both the benchmark and the average passive index tracker. But we also believe that some active portfolio managers possess the skill to outperform the benchmark over the long-term. They won’t outperform year after year but over longer periods of time, like rolling 5 years, the data shows it can be done.

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Note: Past performance is not a reliable indicator of future performance.

So, if you decide active management has a place in your portfolio, it’s important to find top quartile managers, not average ones. 

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The subtle art of avoiding average.

We believe there are some characteristics that separate top quartile portfolio managers from the rest of the pack.

They focus on long term capital allocation….

The line between investing and speculating is often blurred but the act of allocating capital strikes us as being much more deliberate, long-term and strategic.

…and they are laser focussed on fundamentals.

Being a dedicated capital allocator that’s laser focussed on long-term fundamentals and valuations doesn’t mean you will beat the market year in and year out. From time to time the market gets irrational and loses sight of fundamentals and valuations. In this type of environment someone who focuses on fundamentals probably won’t do very well.

They are not afraid to take high conviction views….

Having too many companies in your portfolio means you’re unlikely to be very different to the benchmark. In order to beat the benchmark over the long-term you need to be different. This means taking concentrated, high conviction views. Top quartile investment returns don’t come from doing what everyone else is doing. 

In our opinion 20-30 portfolio holdings strikes the right balance between diversification and conviction. A larger holding in fewer companies means more stock specific risk but also the ability to dedicate more resources to each individual idea. This way you can really cross your t’s and dot your i’s.

….and they take care not to overpay for growth or invest in value traps.

Earlier we said long-term fundamentals are foundational to a robust investing process. There is something else. Valuation. We believe the future expected return for an investment is an intricate trade-off between long-term growth and the price you have to pay for it today. If you overpay, you are unlikely to have a good result over the long-term. Equally, we believe that if you buy something that is very cheap but it is unlikely to grow earnings and free cash flow in the future you are unlikely to make a decent return on your investment.

They have a robust process and stay the course….

One of the quickest signs that a portfolio manager is not worth his/her salt is a jolting/sudden change in process or strategy after a period of poor performance. While this might be a sensible thing to do in other disciplines, in investing it can easily be a death sentence. All portfolios go through periods of difficult performance from time to time. Trying to trade yourself out of a hole or losing sight of the long-term by being emotional and reactive are likely to compound bad results. Sometimes bad things happen to good decisions.

…and last but not least, they check their ego….

There is no place for ego in investment management. No one can predict the future and overconfidence can lead to poor investment results. Great portfolio managers integrate inherent uncertainty about the future into their process through effective risk management.

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So…in conclusion

As we’ve shown above, the average active manager should be expected to underperform the benchmark after fees. So, it is clearly very important to find a top quartile active portfolio manager. We believe there are some characteristics, like a long-term focus, a concentrated portfolio and a robust evidence-based process, that can increase the odds of being a top quartile portfolio manager. These are the areas we will focus on when we receive FCA approval.

Important Disclaimer

Please remember, investing should be viewed as longer term. Your capital is at risk — the value of investments can go up and down, and you may get back less than you put in. 

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References

[1] https://www.tandfonline.com/doi/abs/10.1080/0015198X.2022.2066452?journalCode=ufaj20 

[2] https://web.stanford.edu/~wfsharpe/art/active/active.htm

[3] https://www.berkshirehathaway.com/letters/2016ltr.pdf

[4] https://russellinvestments.com/us/blog/can-active-management-win-long-term