The long and active existentialist

Abstract

This contribution casts a critical eye broadly at empirical active management in the conventional regulated long-active fund setting. All long (fully invested) and active funds (sometimes termed ‘long-only active’) take on risk with regard to some nominated performance benchmark, for example, an equity index. In so doing, they employ a risk budget. We focus on the frequently misunderstood topic of risk budgeting in this applied (as opposed to theoretical) domain. Active investment management is about understanding risk budgeting, and therein, the possibilities, the merits and the shortcomings of being active. We discuss two ubiquitous practical fallacies. The first, while typically understood, is also uncommonly ignored, and relates to the forced coupling of strategic equity benchmarks to sources of value-add. The second misnomer derives, in part, from not appreciating the full consequences of the first. There is a commonly held outlook that the size of assets under management is in some way directly related to the possible size of dollar-nominal value-add. In other words, whereas a large equity asset base (given some skill) can derive a specific dollar-nominal excess return, a smaller equity asset base cannot derive the same without taking on a different (excessive) value of dollar risk. We demonstrate in largely non-mathematical prose that the risks taken to generate the same dollar nominal, for the same skill set, are equivalent. We discuss why an understanding of these issues by trustees, plan sponsors and financial practitioners is going to become increasingly important in terms of being able to successfully navigate the waters (regardless of how choppy) of active management. We argue that many of the current practical debates – ranging from active versus passive investing, hedge funds versus long-active, through to the basic cornerstones of active remuneration – are artifacts of not fully appreciating the finer detail of risk budgeting that is often not easily accessible (although most often correctly stipulated) in the mathematical finance literature.