By Sanjoy Ghosh, Chief Investment Officer of Covestor
Let’s be clear: At Covestor, we have nothing against passively managed index funds and ETFs. We think they’re legitimate vehicles for gaining diversified, low-cost exposure to core asset classes (or “beta” in finance parlance). Index funds hold an important place in our investing philosophy.
But we’re also convinced that adding up-and-coming, active managers to the mix can help investors generate “alpha” (excess risk-adjusted returns).
At first glance, investing in passive index funds sounds like a boring recipe for guaranteed mediocrity. Conversely, investing with a gun-slinging portfolio manager taking concentrated bets in undiscovered companies can sound much more glamorous and exciting.
The reality is different. Passive investing may be dull, but it tends to over-deliver in terms of fulfilling your investment objective. Active investing may sound sexier, but often fails to live up to its promises, and so needs to be handled with care. Many active managers fail to deliver consistent alpha, and eventually their lack of skill is exposed. Countless academic studies have shown that a vast majority of active equity managers trail their relevant benchmarks over the long term. For example, S&P Dow Jones Indices regularly updates its S&P Indices Versus Active (SPIVA) reports, and for actively managed funds, the data isn’t pretty.
But here’s the thing: Just because alpha is hard to find does not mean that it doesn’t exist. We think a large, diverse peer group of alpha-generators on a transparent platform, where you can compare investment performance over different market cycles, is a solid approach for reaching this elusive goal.
And because alpha is different from beta, it makes sense to allocate a portion of risk capital to active managers who employ strategies that have the potential to outperform their peers as well as their passive benchmarks.
That’s how we believe Covestor adds value – by providing investors with a suite of diversified managers on a common platform who are all trying to generate alpha through their unique strategies.
We also believe it makes sense to consider emerging managers with fewer assets under management than the big funds. Why? Because when the size of assets that an active manager oversees increases, his or her opportunities grow more limited due to liquidity constraints. The manager becomes less nimble as assets grow larger. Think of trying to drive a tank through traffic-choked city streets — as opposed to a motorcycle. Many times, the manager is unable to establish a position of sufficient size in the portfolio to move the needle, despite the fact that the manager has successfully identified significant alpha potential.
Academic studies have shown that emerging hedge fund managers as a group outperform more established, larger fund managers. But the dispersion or range of emerging manager performance is also large, so identification of skill becomes even more important. Therefore, it makes sense to invest small, and increase the allocation to the emerging manager as one develops confidence that the alpha-generating process is indeed repeatable.
Or, investors can try to diversify away the idiosyncratic risks of individual managers by investing in a portfolio of several managers. At Covestor, we provide investors access to both single-manager portfolios as well as multi-manager portfolios.
Please note that the issues I addressed in this post are also contained in our investment philosophy.
DISCLAIMER: The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. All investments involve risk, the amount of which may vary significantly. Past performance does not guarantee future results.