Actively managing investment risk
Joel Dresang: Kyle, there’s a debate over whether investors should invest through active management or whether they should do it through passive index funds. One of the things that you point out is that the debate doesn’t include much of a discussion of risk. Can you talk about that a little?
Kyle Tetting: Absolutely. I think when you’re looking entirely at the indexing universe, which a lot of journalists out there have written extensively on the benefits of indexing, I think one of the big things they’re missing is that, yes, you can participate in the returns of the index, but you’re also participating in the risk of the index.
There are a lot of active managers out there who aren’t trying to take index risk, who maybe see some opportunities to be less risky and add some value that way but still participate broadly in the returns of the market.
Joel: So you find that some active management can produce better risk-adjusted returns than the indexes. Are there keys to their success?
Kyle: Absolutely. We use the term “alpha” to kind of define that risk-adjusted return or the return in excess of a level of risk. And managers who typically are very good at generating alpha tend to do two things, and both of them are aligning themselves with shareholder values. That is, one, that they invest a lot in their own fund, making themselves a shareholder in the fund. And, two, that they tend to keep expenses on their fund very low, so that there isn’t a high hurdle to overcome relative to those very cheap indexes.
We talk about this concept of alpha as return above a certain level of risk, and when you look at a low-cost index, for example, the one thing that you’re largely guaranteed is that you’re going to get return less than the level of risk, after you account for the expenses of purchasing into that index.
Joel: Are there certain areas where indexing might be a better idea than active management?
Kyle: Yeah. There is a lot of research into areas of the markets that maybe benefit more from active management or benefit more from indexing.
What we have found is that if you look at some of the more well-studied areas of the market – areas like large-cap stocks, in particular, those tend to be pretty well understood by analysts. They tend to be pretty well covered by analysts, and the market as a whole has digested the news about those companies. Not a lot of opportunity to add value. There still are some managers who can.
Joel: Are there areas where active management actually adds more value?
Kyle: Yeah. We look at areas like the international landscape as a place where managers can really go out and find opportunity. If you look at maybe perhaps smaller companies here in the U.S., where a portfolio manager or an analyst for a portfolio manager can go out and really understand a business, really understand the market that it operates in and find some value that way. Those opportunities just aren’t as readily available when you look at those more well-understood large stocks.
Joel: So what I’m hearing here is that maybe there’s room in a portfolio for some active management and some indexing.
Kyle: I think we’ve really embraced this idea that there is a place for indexing, and particularly in certain markets, there’s a place for indexing.
But if you’re building a diverse portfolio, you want different strategies that complement each other. So, where we’ll take index risk with some of those large-cap positions by investing in a cheap, or low-cost index, we’re also going to layer on some active management to get some diversification, to get some things that behave differently.
Kyle Tetting is director of research at Landaas & Company.
Joel Dresang is vice president- communications at Landaas & Company.
Alpha: Putting investment return in the context of risk, a Money Talk Video with Kyle Tetting Active management: Less risk, more return, by Kyle Tetting Active vs. Passive: Not either/or, by Tom Pappenfus Managing Investment Risk, by the Financial Industry Regulatory Authority
Money Talk Video by Peter May
(initially posted Feb. 23, 2015)