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Should You Actively Invest?

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It is highly questionable as to whether active management is appropriate for investors.

You can find studies [4] that indicate active management can provide superior performance in certain circumstances. But more studies conclude that, over the long-term, active management does not outperform a passive approach.

What do I think?

I believe investors should generally stick with a passive approach to investing. However, I believe that there are times when it is beneficial to use active management. Today we will look at situations where I believe that active management can provide value.

Note that while I shall lay them out separately below, usually a specific investment resides in multiple boxes.

Niche Markets

I believe active management can be used in niche markets that require specialist knowledge.

In niche markets, the number of knowledgeable analysts is less than for stocks and bonds. The less competition in researching investments, the greater the probability that a true expert can find value amongst individual assets. Also, the less competition, the easier it is to differentiate the top experts from the mediocre and poor ones.

Fine art, collectibles, gems, and wine are a few examples of niche markets.

In areas such as these, I believe experts have a definite advantage over most other investors in the segment. Therefore, being an expert, or following their recommendations, may allow for outperformance of the niche market as a whole.

I also believe that expertise in specific fields can translate into active management success even in non-niche markets.

For example, if you are a heart surgeon, you may be able to assess developments in cardiovascular tools and related public companies better than most other investors. Similarly, if you work in the high-tech industry, you may have an advantage in determining which high-tech companies and products have better likelihoods of success.

Investing in market segments where you have better technical knowledge than others may give you an edge when trying to select individual investments.

Inefficient Markets

A tenet of passive investing is a belief in markets being highly efficient.

An efficient market is one where securities’ prices reflect all relevant information. If true, then it is not possible to use active management techniques (individual security analysis and selection, market timing, etc.)  to “beat the market”. A passive strategy of trying to only match the market return is the only investing option.

However, some markets may not be fully efficient. In these markets, active management may outperform passive.

Niche markets are often inefficient.

Do all investors have access to the same information concerning a new artist? Do all investors possess the same skill to assess the quality of diamonds and rubies? Probably not.

Securities markets may be less efficient in developing countries.

Some countries may not have stringent insider trading regulations. Some countries may not have comprehensive reporting requirements for companies. Some countries may be more corrupt than others. Without proper rules and governance, certain individuals may possess corporate information that other investors do not receive. This can lead to inefficient markets and allow the investors with the information to prosper.

Companies that do not trade on established markets may suffer from inefficiencies as well. Shares that trade “over-the-counter” (OTC) tend to have less consistent publicly available information for investors to assess. Compounding this is that OTC stocks often have a limited corporate history in which to examine.

Investors with preferential access to information on investments or possessing specialized knowledge concerning an inefficient market, may succeed utilizing active strategies.

Ignored Markets

Because of perceived inefficiencies in some developing markets, analysts and investors may avoid following and investing in these markets.

Even in developed nations, some market segments may not be extensively covered by analysts. Analysts and investors do an excellent job of monitoring the large-cap stocks. But often nano or micro-cap companies are ignored.

The avoidance is nothing nefarious. Rather, information availability is better with larger companies, so they are easier to monitor and assess. Also, small companies typically have a limited number of shareholders as compared to larger companies. So there is less interest in the market for small companies.

For example, consider China Logistics Group (CHLO), an OTC stock. On October 27, 2010 it had a share price of USD 0.04, a market capitalization of USD 1.58 million, and 39.51 million shares outstanding.

Some investors may not invest in penny stocks either by choice or based on regulations or internal investment objectives. For example, in some jurisdictions funds may not be eligible to trade equities beneath certain price levels or that do not trade on authorized exchanges. As well, a fund prospectus will disclose the investment objectives and any constraints that may be imposed on investment options. As a result, some funds may not be able to invest in China Logistics, so their analysts do not cover the company.

Other investors or funds may avoid nano-cap companies on logistical grounds.

Consider the Fidelity Advisor Small Cap Growth T (FCTGX) mutual fund. It invests in small-cap stocks, so perhaps China Logistics is of potential interest. But if we look at the Fidelity fund, we see that it has assets under management of USD 1.5 billion. China Logistics only has a market-cap of USD 1.58 million. All it would take is for Fidelity to invest 0.1% of their assets into China Logistics and they would own every available share. And given restrictions on ownership levels in companies, Fidelity would not want to own 100% of China Logistics.

Imagine Fidelity investing in a slew of China Logistic size companies. Investing less than USD 0.5 million in company after company would be a logistics (no pun intended) nightmare for Fidelity. That would be 3000 companies to trade, monitor, and account for. Not the easiest, wisest, or most cost-effective proposition.

With less investors seeking opportunities in ignored markets, those that do may find active strategies successful.

Note that trading OTC shares can be a high-risk strategy. The lack of publicly available information, possible lack of corporate history, and potentially less rigorous regulatory oversight increase risk for these shares. Further, there are also liquidity issues with many of these companies which can impact one’s ability to trade the stock. I suggest extreme caution should you ever decide to trade OTC stocks.

Long-Term Market Phases

Market timing can be a costly strategy for investors. It is not an easy thing to do and if you are late to either enter or exit a market as it changes direction, you can lose a fair bit of money. Please see my discussion on investment bubbles [5] for problems with market timing.

And based on many studies, it does not seem to be a successful long-term strategy to pursue.

However, I do think that sophisticated and professional investors can take advantage of long term market phases to beat a benchmark over the short-term.

In prolonged bear markets, by moving portfolio assets into cash or defensive assets, a prudent investor may be able to protect the portfolio. When the market turns upwards again, the investor divests the safer assets and returns to the relevant asset class.

In lengthy bull markets, allocating capital into higher risk (with higher expected returns) assets or using leverage and derivatives may enhance the bull market impact on one’s portfolio.

Of course, shifting assets around in one’s portfolio requires incurring extra transaction costs.

It also may trigger premature taxable capital gains upon the sale of an investment that was sold due to market timing.

These costs, along with the cost of not timing the market swings correctly, can have a significant, and negative, impact on your performance. They are a major reason as to why active management suffers in comparison to a passive, and non-trading, approach.

Conclusion

These are the areas in which I think investors can successfully utilize active strategies to outperform a passive approach, at least in the short-term.

In each circumstance, specialized knowledge is necessary to take advantage of the situation.

If you possess expertise in certain fields, I suggest you incorporate that knowledge into your overall investment strategy.

If you do not possess the skills yourself, you can pay someone to provide the service for you. However, the greater the expertise required, the greater the management fee charged. And the greater the fees, the higher the returns needed to beat the passive benchmark. When outsourcing technical expertise, be sure that you are receiving value (in the form of superior performance) for the price you are paying. In most cases, you do not.

In each area above, investment options tend to be relatively high risk.

Before you invest, make certain you understand the risks associated with investing in niche markets, developing countries, OTC shares, and the like. Without the specialized knowledge of the market, your odds of success are rather low.

Next we will look at passive investing.