by Mark S. Rzepczynski, CFA
A manager's chance of outperforming the market after fees is less than a flip of a coin. Not every manager can be above average. Active management against a benchmark is a zero-sum game, with wealth often just transferred across investors. Paying high management fees is an easy way to destroy value, and the only ones who often get rich are the firm's management.
With respect to return to risk efficiency, the concept of passive investing fares no better when applied through cap-weighted indices. Current-performance measures of success are often inaccurate for a host of reasons, including survivorship, size effects, wrong benchmarks, and the simple fact that management styles move through long cycles. In the long run, good investment behavior will not translate to good performance in every period. Investors are often confused about the benchmarking process or even fail to understand the factors that lead to efficient portfolio management.
Jacques Lussier presents this devastating critique of the money management industry's current state as the starting point for his new investment book, Successful Investing Is a Process: Structuring Efficient Portfolios for Outperformance. However, his book provides some hope for what may be the pipe dream of investment success through his extensive review of research evidence coupled with simple, real-life investment analysis. His solution is a clear focus on process and protocols, grounded in evidence that can be implemented easily. A manager need not be an extraordinary quantitative analyst or an asset-picking star but, rather, need merely use the extant rich knowledge on good portfolio management techniques.
Research evidence provides investors with many effective guides for improving investment performance. Although success can be made easier to achieve, investors too often do not wish to be confused by facts that contradict their entrenched views and interests. Lussier provides 50 years of theory and empirical evidence to demonstrate how to bend the odds in favor of portfolio efficiency gains. Investors have only to follow the wealth of existing evidence; Lussier does the hard work of synthesizing an effective road map of efficient techniques. He takes what is known through research, tests it under controlled comparisons, and draws conclusions for enhancing active management.
Successful Investing Is a Process is divided into four parts. Lussier's harsh review of the active management business sets the stage for his thesis on process. Given the failure of current active management, there has to be a more effective alternative for running a portfolio. The second part focuses on understanding the dynamics of portfolio allocation and asset pricing. Although this area should be self-evident for students of investments, Lussier examines some primary but often underweighted issues that drive portfolio performance. The third section develops the components of an efficient portfolio assembly process, the necessary tools that allow for outperformance. The final section discusses the creation of an integrated management process that combines the key concepts presented earlier with liability management.
Understanding and managing the dynamics of portfolio allocation and asset pricing can take two tracks. One track focuses on return generation. How does one outsmart the market through active management - that is, picking the right assets? Unfortunately, a lot of smart people play this loser's game. The other track focuses on what could be low-hanging fruit from managing portfolio structure and risk. If one focuses on structure and not on picking individual assets, one can produce more efficient portfolios without having to be a superior forecaster. This second track - portfolio efficiency- is Lussier's secret for success, which encompasses four major but simple dimensions.
Volatility matters. Volatility is a significant drag on geometric returns. If one can control or reduce volatility, one can get a free lunch. Hence, leverage is not a long-term solution. Benchmarks, rebalancing, and diversification are critical value creators. Increasing the arithmetic return is possible through the right portfolio structure - for example, avoiding cap-weighted benchmarks and using some simple forward-looking indicators concerning relative performance across asset classes. Maximizing tax efficiency adds to returns without having to forecast them explicitly. Finally, formal understanding and proper managing of the objectives of the portfolio are straightforward but often underrated as an area of efficiency gains.
Those factors that drive returns can be incorporated into portfolio management in ways that help boost portfolio performance, but again, the focus should be directed more toward efficiency through improving diversification. Blending value, momentum, size, and book-to-market ratio can help diversify risks and generate better portfolio returns. Nevertheless, this book is most helpful in showing the value of non-market-cap investment structures, whether risk based or fundamental. Equal weighted, equal risk, minimum variance, or maximum diversification - all, in Lussier's view, can be "protocols" for reducing or controlling risk. Given current technology, fundamental-weighted or high-dividend-yield protocols can also be easily built. The result shows long-term excess return at similar or lower volatility. The cost is higher turnover, but the efficiency improvement is a simple management process exhibiting clear evidence of outperformance that does not depend on the active management of picking winners.
Another simple method for adding investment value is a rebalancing mechanism. If based on portfolio behavior and not just calendar time, rebalancing can use underlying market characteristics to control volatility and return. Asset allocation that is based on either factors or multiple asset classes to diversify risk can also be used to improve portfolio efficiency. These approaches all minimize tail risk. And there is no need to pay premium hedge fund fees for these protocols.
Still, diversification without a strong theoretical foundation is flawed. Using commodities and currencies as representative areas, Lussier demonstrates how theory with evidence can provide a rationale for when to add these asset classes. Another ongoing issue that has received little attention is tax efficiency. Contrasting Canada with the United States, Lussier shows how different tax structures require different management behaviors. The weak emphasis on tax management by investment professionals is unfortunate; however, tax efficiency frequently conflicts with investment protocols that create more turnover.
All these protocols are of little consequence if the process is not consistent with liability-driven investment (LDI) management. Too many want to manage assets without understanding the complex needs and objectives of the client, yet matching assets with liabilities is critical to management success. Managing liabilities is not a strategy but, rather, the ultimate process of wedding the asset portfolio with an investor's objectives. To some, LDI management has become a buzzword for the simple awareness that portfolio choices must be made in the context of the investor's life cycle or a plan's objectives; it is broader and more strategic. Focusing on such issues as inflation risk, liability hedging, and downside protection is vital for getting the portfolio structure right. Perhaps this approach is too simple, but it is often overlooked.
Lussier's various protocols are uncorrelated, and so a combination can be used to better manage overall risk, with a tilt toward the liability objective. When all these protocols are incorporated, the author demonstrates that objectives can be reached more efficiently without significant forecasting insight. Although there may be better managers over short periods, short-term performance will not always translate to long-term gains. Lussier shows how to play and win the long-term performance game.
This one book contains all the relevant research evidence on active portfolio management. Indeed, Lussier almost overwhelms the reader with evidence in an attempt to be thorough, upsetting the balance between helping the reader and providing completeness. The audience for this book should be the practitioners who have failed at active management and not the academics who have already studied these issues but want a complete discussion. This balance between thoroughness and focus could have been tilted more toward the needs of practitioners.
Only an author who has had a foot in both academe and the real world could have written this type of book, but shifting between the two worlds is never easy. What makes Successful Investing Is a Process special is the unfaltering focus on the evidence. In the acknowledgments, Lussier comments that this is the one book he wishes he could have read early in his career. On the basis of the evidence presented, I would agree with the author's self-reflective comment from the wisdom of age. If I had read this book earlier in my career, I would have been a better manager.
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