The 401(k) industry braces itself for fruits of a CalPERS rethink that reflects a cut-the-crap mentality about active investing

Dan Solin, Robert Boslego, Lou Harvey, Mike Alfred and many thoughtful advisors engaged in portfolio management to include CALPERS all cite there is little to support active management. So why is active management so prevalent?

Could it be that for centuries the industry has not been focused on portfolio construction, fiduciary duty and professional standing (which is why it is illegal for brokers to say they render counsel) and thus the industry has a built in bias toward expensive packaged products geared toward active management and associated higher cost as a means of compensating sales and carrying the high overhead of the brokerage business model. Of course sales commissions and high sales administration cost and compliance overhead is not required in advisory services. Thus the only rationale for supporting active management is its traditional role as a primary means to support an increasingly outdated brokerage business model which is expensive, does not acknowledge or support brokers rendering advice where the broker is not accountable for recommendations and has no ongoing fiduciary duties in the clients best interests.

The proof of this thesis is RIAs have control over their value proposition, cost structure, margins, transparency and professional standing not possible in a brokerage format. This allows RIAs to offer an unprecedented level of expert individualized advice at a cost lower than a packaged product (which by definition can not be client specific) while compensating the advisor as much as 50% better than a broker.

The ultimate test of active vs. passive is the consumer who gets better un-conflicted expert counsel at a lower cost while more effectively incenting professional standing in the consumer’s best interest.

The RIA business model is embracing values that are reordering the financial services industry in fundamental ways as the broker of the future is an advisor who is perfectly aligned with the best interest of the investing public. The only case for active management is the perpetuation of the high cost, low value added brokerage business model which advance brokerage interests ahead of that of the consumer. The consumer always wins in a free market thus assuring CALPERS and others will adapt to the active management of passive investment management strategies. This is just the free market at work and is highly predictable.

Please take note of the position of the nation’s leading institutions, not just CALPERS. What position are broker/dealers and custodians taking? How about regulators charged with protecting public trust? We are about to witness a new line up of “leading” firms and organizations based on their tangible support of professional standing, the consumer’s best interest and the trust and confidence of the investing public.

Where does your supporting firm stand in the provision of the tangible enabling resources required for professional standing? Are they making advice safe, scalable, easy to execute and manage as a high margin business at the advisor level?

Do they even see the need to support your professional standing in your client’s best interest?

That will determine if you are at a “leading” firm.

SCW

I am shocked at how so many smart people have fallen so completely for the flawed “passive-is-better” story and take it as given that somehow “academic research” has conclusively shown that active management is a losing proposition. Actually, there is plenty of academic research on both sides of this question if you care to do the work to find it. More importantly, in real life there are many examples of skilled active managers who add value consistently over time after fees. Who cares what the “average manager” does after fees? The average journalist, the average consultant and the average academic researcher/professor don’t add much value either. Finding skill is hard in any area and you won’t be able to find skilled active managers using most of the tools that are commonly used today. Before you all throw in the towel and mindlessly repeat the marketing palaver from the product manufacturers who offer passive strategies, do a little more homework. You might be surprised at how wonderfully complex the world actually is.

Scott,

I’m amazed how long it’s taken for anyone to challenge on this issue. Is there a go-to study you could point to that demonstrates that we shouldn’t throw in the towel on active management?

I love this point!: 'The average journalist, the average consultant and the average academic researcher/professor don’t add much value either.’

I admit i feel a little brainwashed by studies showing, for instance, that Five-Star Morningstar ratings aren’t of much predictive value. Still, God knows, the marketing palaver coming out of the active management camp is of higher volume than what the passive side produces. And on average, your average person is going to be subject to average managers, logically speaking, so there needs to be some concern about what comes out of that average meat grinder.

Thank you for raising these issues,

Brooke

Hey Brooke,

I am on the road right now so I don’t have access right now to all the research I keep in my office that supports the proposition that active management can add value, but my favorite studies on this point are by Russ Wermers at the University of Maryland and Cremers and Petajisto, who used to be at the Yale School of Management. Here is the real problem, as I see it. Most of the information that is floating around on both sides of the argument is generated by product manufacturers who are clearly driven by their interest in selling products. The academics suffer from the fact that they are, well, academics. They do not have very much practical knowledge about the topics they are researching—they grind numbers/data, sometimes using mathematical techniques that are inappropriate. The product-pushers cloak themselves in whatever academic research suits their purpose. Their are skilled active managers, but the tools it takes to find them are not used on a widespread basis yet. There is no “right way.” Passive is fine if you don’t know how to find skilled managers. But they are there and can be found if you know what you are doing.