There are only so many aspects of the investing process that we can control. Categorizing these elements will serve as an outline for our research. Let’s outline the active management process and try to leave no aspect uncovered. Your comments here—on elements that I’ve missed—would be much appreciated!
This outline will be for a portfolio of stocks only. Several of these elements blend together.
- Strategy
This is a huge category. But ultimately every active manager is collecting, adjusting, and processing data, evaluating that data (deciding what matters and what doesn’t), and reaching buy/sell decisions. Active managers approach these three steps in a million ways. We will do our best to evaluate each of the three levels.
- Concentration & Portfolio Construction
How many stocks should you own? How much diversification is too much? We will explore this under appreciated topic in detail, mainly in the context of factor investing.
- Trading frequency and method, time horizon
This overlaps with portfolio construction. How does a manager put their strategy into action? This includes behavioral foibles, because buy and sell decisions are often the result of our mis-calibrated psychology. Turnover is demonized, but in order for some of the best investment strategies to work (e.g. momentum), turnover is necessary.
- Costs
- Taxes
- Market impact
- Commissions
- Fees
Donald Rumsfeld might call these costs the “known knowns” in investing. We can keep costs down in a number of different ways to avoid what Jack Bogle calls “the tyranny of compounding costs.” These will be important to consider alongside #3. The key is a balance of costs with the benefits expected by incurring those costs.
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We will consider these important categories in isolation. What are the options within each? What are the relative merits and dangers of each option? How can investors find the style that best suits their needs and their temperaments?
While important in isolation, these categories are most important in combination. For example, it may make sense to concentrate a value-based portfolio more than a momentum-based portfolio. Ditto for trading/rebalance strategies.
There are never silver bullets in investing. There is no perfect strategy. There are a number of strategies—themselves quite different from one another—that have worked well historically.
There is no one statistic that is best for evaluating a strategy, either. Instead, a suite of statistics is best: t-stats, returns, consistency (base rates), sortinos, omega ratios, drawdowns, diversification, liquidity, and so on.
Perfect is the enemy of good, in this case. Nothing will be perfect, but perhaps we can put the odds more firmly in our favor.
What have I missed? What else should we consider? Let me know in the comments below.
P.S. Luck would be a fifth and final determining factor—one that is sadly out of our control. We can investigate measures of skill like information ratio, but there will always be some component of luck in any investment outcome.
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“it may make sense to concentrate a value-based portfolio more than a momentum-based portfolio”
There is a lot to consider when constructing a portfolio but I will pick on this one comment. Concentration does seem to help in the case of value to a point and the same seems to be true of momentum. There are 2 types of momentum. Absolute momentum is a matter of whether the price is positive or negative over any given period of time. Relative strength momentum is a way to compare the performance of different securities over the same time frame. So while a group of securities might all exhibit negative absolute momentum one of them will still have the ‘highest’ relative strength. Meb Faber, Gary Antonacci, and the fellows at Alpha Architect have all shown that holding more concentrated portfolios in the long term using a momentum style tends to outperform more diversified portfolios. However, like a value approach, if you only have a single holding you will get much higher volatility while only receiving marginally better returns versus a portfolio with 2 holdings. As you begin to add more assets the effect diminishes because the relative strength effect also diminishes. This also occurs as the value effect diminishes when you add value securities that are more expensive but still considered values.
Perhaps when constructing a portfolio you could diversify by style: 33% Value 33% Momentum and 33% Non Correlated assets or something like that. And as the risk profile of the account holder changes you could modify the strength of the style and volatility by altering the concentration of the holdings? Risk down concentration down (Risk=Concentration)
In summary:
It would be useful to know how much to allocate to different styles as well as the concentration within each style based on the acceptable level of risk. It would also be useful to know what is my level of risk? Perhaps I am taking on too little risk. How do I know what an appropriate risk level is for me?
Perhaps it would be worth talking about how to think about sizing an active bet on the basis on some measure of conviction or margin of safety.
I didn’t see it mentioned, but we know that many successful value investors use various ranking systems based on some perception of margin of safety to size their active bets or even pick the most attractive opportunities for portfolio construction.