Active Investment Management, LLC

“Active investment management is taking an active role in the ongoing process of investment selection and risk management with the objective of improving a portfolio's risk/reward relationship.”  Another definition would be “The science of determining which asset class has statistically the best chance of providing positive returns as determined on a daily basis.”

To clarify how it differs from traditional investment disciplines, such as “buy and hold” it is necessary to explain those further.  Buy and hold is a discipline, when coupled with Modern Portfolio Theory (MPT) that constructs an investment portfolio that considers the risk and time horizon of the individual investor.  The end result is typically comprised of several (if not all) assets classes, that is, stocks, bonds and cash.  Some also include real estate and precious metals.  Most assuredly the more sophisticated portfolios will contain different classes of stocks (large, mid, and small cap, growth and value) and bonds (government, corporate, and municipal, investment grade and ‘junk’) to provide a fine-tuning of the risk/reward parameters.  Typically this is the method used by the average investor.  Recent research has introduced probability testing based on history of varying market performances.

The problems with buy and hold are as follows:

 Buy and hold is simply that.  Hold on to the investments no matter what the market is doing.  This means that if the market goes up, your portfolio should go up and vice versa.  It’s the vice versa that is the problem.  As we all clearly and painfully have experienced twice in the last ten years, this provides a great opportunity to lose vast sums of money. 

1. MPT taught us all to diversify.  While in minor market corrections this mitigates the potential for loss, it cannot remove it completely.  It was designed to take advantage of the history of the various markets to not all move in the same direction at the same time.  While stocks may be on the rise and bonds on the decline, the overall affect on the portfolio is lessened.  However, there is no provision that allows for making money (or at least breaking even) when either or both are falling.
2. Both of these rely mostly on traditional fundamental research to select investments.  Whether buying mutual funds or individual stocks, more often than not these are based on the recommendations of individuals who have looked ‘at the numbers’, economic forecasts, government statistics, and any and all subjective factors and suggest that Company A is a buy, or mutual fund Z did well last year so….
3. Probability testing was borne out of Monte Carlo simulations, which when simplified, means they take all the yearly performances of an index, throw them all in a hat, and pull them one by one and record them consecutively so that you will have put together 70 years of returns in random order.  Then they test the portfolio to see how it performed over different time periods.  And they do this thousands of times.  The result will show the probability of the proposed portfolio’s ability to provide a positive return over 1, 2, 5, 10 year period.  The problem is that those years when the market does poorly still exist.  They haven’t been addressed in such a way that considers how a positive result can come from a negative time period.  And the investor has bought and is still holding.

Active investment management differs in a number of ways:

1. By definition, selection.  This, depending on the active manager’s system, could be market segment, time period, and amount of portfolio invested.  For example, a given manager may specialize in the S&P 500 index and on a regular basis will decide as to when and how much of the portfolio he believes his clients should be exposed.  This of course includes possibly being invested in such a way that allows money to be made if the index falls.
2. The process is objective, that is, without emotional input.  Most, if not all, active managers employ models that are based on strict mathematical rules that have been tested continuously and rigorously over long periods.  Unlike fundamental research, in a quantitative approach, the formulae make the decision.
3. The risk management in the active manager’s approach can be twofold; as stated above by controlling dollars invested at any given time, and by when to be exposed to the market, either up or down.  This is a key feature and the most important difference.  Having the ability to be invested (up or down) or to be 100% in money market is not possible or, in some cases, not practical, with traditional investment disciplines.
4. All of these lead to the goal of improving the risk/reward relationship.  If risk can be objectively and statistically managed then the reward should increase.  The above are risk-controlling factors, and active managers base their theories on varying levels of risk exposure with respect to the expected reward.

All mutual funds have some degree of active management in that securities are added or removed on a regular basis due money flows in and out, or securities coming into or falling out of favor.  Or perhaps the investment professional looks over the investors account on a weekly or monthly basis.  The active manager typically decides on a daily basis how money should be invested for the next day.  Not next week, or next month, but the next day and only the next day.  Recent markets have shown us that trying to predict where the markets will be in the next month or year will be is less accurate than predicting the weather a week or so in advance.  However, while not always correct, predicting the weather for the next day is much easier.  It is not that easy with the market, but if wrong, the active manager won’t be wrong for the whole year. 

This may all sound like active managers are trying to time the market and in fact, that is largely true.  Most investors have been conditioned that timing the market doesn’t work; that if you miss the 10 best days your return would be X% less.  What they don’t tell you is that if you missed the 10 worst days, your return would be Y% more.  And in this case, Y is bigger than X.  What is important to understand is that there exist 100’s of investment firms that were built around the theory of buy and hold.  They have billions upon billions both invested and under management based on this theory.  It is not being suggested that these firms are in cahoots or are pushing some kind of conspiracy.  Quite the contrary.  Buy and hold is a viable investment strategy if you time horizon is long term, meaning now-a-days 20 – 30 years.  (It used to be 10 years but where were we 10 years ago?)  These same investment firms, in the late 1990’s, banned the ability to exchange freely between funds on a daily basis because too many people were doing it.  It only makes sense that if so many people were doing it, they were making money doing it, and therefore timing the market does work (if one knows what one is doing).  Mutual funds changed their prospectuses to prohibit such practices as it interfered with the ability of the fund manager’s ability to manage the fund.  Another reason for the ban on daily exchanging was that the “timers” were sharing in the gains of the fund and not the losses.  Doesn’t this sound like the timing was working?

For the period 1980 through July 2016, there were 9233 trading days, 4909 were up, 4341 were down and 1 was unchanged for the S&P 500 index.  That equates to about 53% up and 47% down.  We all know that Las Vegas was built on winning margins slimmer than this.  And the S&P 500 index did go from 105 to 2182.  But it wasn't straight up.  There were losses lasting anywher from a few months to about 3 years totalling -42%, -49% and -55%.  

The point is so much of the success of the buy and hold theory is based on being invested long enough to weather the up and down cycles of the markets, and that eventually a profit will be realized.  The obvious flaw is that it depends a great deal on when an investor starts and when he needs to access the money.  So is it a better theory that you plow all your money into the markets when they are down and some years down the road hopefully retire and put all your money in CDs when the markets are up?  Absolutely, but if anyone could plan and read the markets that well they wouldn’t need to work at all.

It is a much easier task to look at the markets on a daily basis and make an intelligent assessment as to what will likely happen the next day.  It is a simple concept, one that everyone can appreciate and grasp.  There is no guarantee that such a prediction will be correct but the probability that the decision will be correct is higher than the probability of predicting where the markets will be in 10 years.  This is not like flipping a coin.  On any given day, the odds that the market will be up or down are not necessarily 50 – 50.  Each coin flip is an independent event; the markets are influenced by many events on a daily basis.

Active management has several advantages over buy and hold with the ability to still diversify over several market sectors.  The practice has been in use and refined for over three decades.  Considering the ability of active managers to be fully invested in such a way as to make money in an up or a down market or be completely risk free (in money market) on any given day is a feature that the mutual funds or investment managers do not offer.