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FINANCE | 07.02.2020

The Fundamental Law of Active Management

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 Ismael García Puente

Investment Manager & Fund Selector

In 1989, Richard Grinold published an article titled “The Fundamental Law of Active Management,” in which he proposed an easy way to predict a fund manager’s chances of outperforming their benchmark in terms of profitability. According to the Berkeley University professor, a manager’s success, or lack thereof, is determined by two variables: their skill and the breadth of opportunities.

The first concerns the manager’s success in picking the right companies or bonds to invest in. Anyone who has experienced just how difficult it is to pick the right stock on their own will know that the odds are always stacked against them because: “We know that the market will move, but not how it will move after investing.” The same holds true for professional fund managers who have to decide in which assets to invest the money of all their members. Their successes are typically small victories that, in most cases, take a while to pay off. And, in a market of the kind we are seeing now, choosing the best fund managers is more important than ever. If it were not so, we would be in danger of following the market in such irrational times as seeing a bankrupt company gain 400 percent in value within a week or a Chinese company doubling its stock market value in a day just because its name (Fangdd) resembles the FAANG acronym, which refers instead to the five tech giants (Facebook, Amazon, Apple, Netflix and Google). However, these behaviors are blamed on zero-fee online trading platforms, where many investors, unable to place sports bets during the lockdown, seem to have resorted to investing in stock as a substitute fix. The end result is a market dominated by massive injections of liquidity by central banks and “irrational exuberance” by retail investors, in sharp contrast to the steady and relentless increase in the equity invested in money market funds by professional investors.

The second of the variables that Grinold raises in his model is known as breadth, meaning the number of investment opportunities a manager has. It should come as no surprise after what we just said in the previous paragraph that the universe of investment opportunities currently available to managers is probably the widest we have seen in recent years. Empirical studies have shown that, when volatility is high, there is a sharp increase in the dispersion of returns between different securities and sectors. Having witnessed extremely high volatility during the months of March and April, and with volatility still remaining high today when compared with the historical average, professionals now have extremely fertile ground in which to sow the seeds for future success.

In any case, the pandemic has accelerated our world and everything is now happening very quickly. Remote working took over in barely a week and we are likely to see an effective vaccine against COVID-19 in a matter of months. Previously, vaccines would spend years in development. In the same way, the favorable conditions of the variables that make up “The Fundamental Law of Active Management” are already bearing fruit. After several years of poor returns and dramatic growth in passive management, we are now seeing mutual funds that have outperformed their benchmarks since the onset of the pandemic, as well as ETFs that are comparable to such an extent that we would be wise to take note.

While it might seem a tad presumptuous to predict a manager’s skill at outperforming their benchmark based on two variables alone, it does offer us a useful framework in steering us toward those managers who will take care of our savings and make them grow over time. With more mutual funds now available than there are quoted shares, choosing the fund that best suits our goals is no easy matter. On this point, we need only refer to another, this time unspoken, law: “Good financial advice is always better than no advice at all.”