What is the Formula for Successful Active Investing?

There has been a lot of talk over the past few years over passive investing over active investing. I’ve talked about it a lot with both clients and in writing about it in the past.  It is a simple mathematical fact that passive investing will outperform the vast majority of active managers because by definition, the passive investor will get average performance with lower fees (typically). A lot of people stop thinking right there and just say yes, I will do passive management.

There is nothing wrong with this. A passively managed portfolio of indexes can work just fine and is probably not going to be the difference between financial success or failure.  For people who are not interested in learning about investing themselves, or who do not have a trusted advisor, passively managed index funds can be a great solution. They are not however, the ONLY solution, and they are often not the BEST solution.

Actively Managed Funds

An actively managed portfolio can provide a lot of value to investors but whether or not it will provide value depends greatly on your ability to identify the active managers who will outperform BEFORE you invest, not AFTER those returns have already been earned.  Many investors pile into active managers who have a successful track record like Kathie Wood’s ARK ETFs.  Buying a fund AFTER it has gone up 100% in a year does not mean you should expect similar performance going forward.  It might, but there are many actively managed funds which go from being the best performing fund one year, to the worst performing fund the following year.  Identifying who will outperform over the long run requires a more in-depth analysis of how the fund manager is actually investing than simply looking at their past performance record over the past year.

Luckily for us, there is a formula for successful active investing. It’s a formula which has been used for many years by a number of different successful investors and has been proven to work.  If you find a manager who uses the formula, it is not a guarantee of success, but what it does guarantee is that the manager is doing all the right things in order to be successful.

The formula for successful active investing has a few components. These components are:

1. Concentrated portfolios
2. Low turnover
3. Making good investment selections which is usually evidenced by generating strong returns (preferably over a longer period of time)

Concentrated Portfolio

One way of measuring these attributes in an easy way is a metric called Active Share.  Active Share measures how different the active portfolio is from the benchmark index which it competes with.  A fund with high active share of 80% or higher is very different from its index. A fund with lower active share of below 80% starts to look a lot like the index and therefore is much less likely to outperform the index.  We always look for fund managers with a high Active Share.

Low Turnover

If you then layer on the second attribute of the active investing formula which is low turnover, you can really start to identify active managers who are likely to outperform.  If those managers who you identify with these attributes also have a long track record of outperformance, you can be reasonably confident that track record will continue.

Despite this formula being readily available to all investors, 90% plus of all actively managed funds actually demonstrate the opposite attributes.  They are highly diversified, low active share portfolios with high turnover.  As a result, they almost always end up with lower performance numbers over longer periods of time.  Why does the fund management industry still operate this way if a high active share, low turnover portfolio gives them a much better chance of success?

What to Consider when Investing in a Fund That Follows the Formula for Active Investing

Investing in a fund that follows the formula for active investing comes with some difficulties and problems, and that is why they are often overlooked by investors.  The problems are:

1. Volatility of the funds is high, and that means that many people would view them incorrectly as higher risk.
2. Drawdowns of the portfolio at times can be large.
3. Relative underperformance of the portfolios against a more broadly diversified index can be quite high at times.
   

In other words, there are times where it can be very tough psychologically to actively invest in the best way.  You will have to endure periods of underperformance, you will have to endure high volatility, you will have to endure large drawdowns, and since most investors are not investing like you, you will have to endure all of these things alone!

This can be very tough, and it’s the reason why so few people invest this way. Most fund managers try to minimize the volatility of their portfolio by being more widely diversified.  While that might make it easier psychologically for their investors, it is not a good recipe for actually outperforming. That’s why we believe there is so much value in investing in an actively managed portfolio that follows the formula.  High active share, low turnover portfolios is the way we like to invest, and we think that will be the best option for our clients.

- Craig White, BA, LL.B., CIM®

Craig White is an Investment Advisor at Endeavour Wealth Management with iA Private Wealth, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Craig White an Investment Advisor for iA Private Wealth and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.