It seems pension funds are moving away from active money management toward passive equity index investing. However, the type of active money management that is under-performing is far different than the active money management that you’ll hear me talk about. I really don’t like the former, but I love the latter. Let’s discuss.
I just read an article in Forbes highlighting that the largest US pension fund, CalPERS, is considering increasing its equity allocation to a higher concentration of passive equity index investments vs active money management equity investments. The reasoning is that only about 25% of the time does the active stock picking manager outperform the benchmark. This is not enough to offset the managers who under-perform their benchmark or index. It appears CalPERS is striving to just match the index or benchmark. That would be a worthy goal if it included lowering the risk of matching market returns.
The Growth of ETFs
I have written about this for a number of years. Passive equity index investment usually outperforms high priced money managers and mutual funds that try and pick stocks. Passive equity index investment can be accomplished by investing in ETFs. More and more people are starting to understand this evidenced by the fact that ETFs have been experiencing net inflows and mutual funds and stock picking money managers have been experiencing net outflows for some time.
Two Kinds of Active Money Management
First we must note that active money managers and mutual fund managers are only active in the sense that when they sell a stock they must replace it with another stock as their mandate is to stay fully invested. They don’t have the opportunity to go to “cash.” So don’t confuse “active” with “going to cash.”
The only way to avoid a significant bear market is to go to “cash.” It’s highly unlikely that your advisor will ever call you to sell something. How can we avoid a significant bear market with this strategy? We can’t.
So, if a passive ETF strategy outperforms traditional “active” mutual funds and money managers, what can outperform a passive ETF strategy? Well, that would be an active ETF strategy—active in the sense of going to cash to avoid most of a bear market, not active in the sense that we are simply creating a revolving door of stock picks that we hold for a few weeks, sell, and replace with other stocks … yet always staying fully invested. Active in the sense of reacting to long-term trend movements and utilizing the ability to go to cash, which most fund managers aren’t even allowed to do due to mandate.
Unfortunately, there are no “Wall Street PrePackaged Products” available that attempt to do this. Why is that, when every successful professional trader knows that the only way to beat the market with less risk is to have a sell (go to cash) strategy?
Why Wall Street Refuses to Advise You to Sell
I will tell you the answer. It’s not in Wall Streets best interests for us to “go to cash.” Wall Street wants us to think it’s always a good time to either buy or hold. Selling and going to cash might be in our best interest but it’s never in Wall Street’s best interests. Can you imagine a company telling you “we don’t think you should buy our products at the current time”? It won’t happen. There is an inherent conflict of interest.
Taking advantage of this inefficient deployment of capital is critical to our success. If we don’t have a sell strategy, we are left with a hold strategy which is subject to disaster. CalPERS is starting to get it … almost. I believe in taking advantage of market inefficiencies. If you really think about and understand the dynamics of the market you can begin to embrace a sell strategy that can outperform the market.