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What chess has to do with asset management; a reflection on passive versus active fund strategies

This note is not about a new topic. It is not even something we never wrote about before. But sometimes you have a bright moment, which can then be translated in a more precise representation of your worries when it comes to discussions about 'active' versus 'passive' fund management.


Finding top chess players really easier than finding top investors? We doubt it.

Market Efficiency
Markets are not 100 percent efficient. This implies that there are inefficiencies that could be translated into above-average return/risk ratios. Obviously, since we are talking about markets here: what the smart investor is winning through an above-average result is lost by others. Similar to chess, where there is always 1 point to be distributed per game via either a 1-0, 0.5-0.5 or 0-1 result. The only difference with the financial world is that the market game sometimes awards 1 point per game, sometimes 2, sometimes 3. There are good and bad periods. But the average player always gets approximately have the points.

For financial markets this translates into the average result being therefore equal to the market return/risk ratio.

Not every market is as inefficient as others. The larger the information flow about a market and its constituent financial securities, the more liquid its trading and the better the information quality, the less inefficient it is. And also: the more volatile a market, the larger the potential for catastrophe for those that don't understand it. Bad news for them, but great news for their opponents: the grandmasters.

Therefore: the probability of beating the average is larger in the Emerging Markets than it is in - let's say - US Large Cap Value strategies.

But in neither case it is impossible to outperform: compare it with different openings in chess. It can be proven that one opening leads far more often to draws than the other, irrespective of the level of play.

Taking all this into account,  the likelihood of the opposite statement being true - asset managers cannot beat their benchmark structurally - is more outrageous and extreme! Compare it with chess again. There are grandmasters who beat the average club player. There are also club players who are lousier than others. And there are also rating systems to keep track of all of this.

Grandmaster players and grandmaster selectors

So basically, when hearing the well-known statements that asset managers cannot outperform and that you should opt for cheaper ETFs (=exchange traded funds) with a passive strategy and not for more expensive (gross) active strategies that try to beat the index, this is only true to the extent that we cannot FIND the grandmaster asset managers. But our not finding the grandmasters doesn't imply that they are not there. Just like the average club player in chess wouldn't be able to really analyze performance qualities in a specific opening when comparing grandmaster X with grandmaster Y.

In other words our not finding the winners means that we didn't know where to look for them and how to find them. It is first and foremost a statement about our search qualities and not about grandmasters being there or not.

After the crisis the call for passive management has grown. Normal! After a period of disappointment one tends to stop believing in excellent result. Just like the little chess prodigy comes back home crying, after losing against that shrewd, older and more experienced top player. This notwithstanding the fact that overall he is far more talented than the old guy! The market is not an easy opponent, and there can be periods in which we have to sit still and wait for our revenge. Again: no big difference with chess.

Now, isn't it true that those who want us to go passive, are probably not active management specialists themselves. Otherwise they wouldn't come up with that suggestion, knowing that fees can be higher in active management. So they want us to follow their passive - index - strategy assuming that those active managers who are good this year will underperform next year and also end up with their same gross average return, albeit with higher costs.

Makes sense? Not really: the more people will go for just the average (i.e. buy the index), the easier it will be to beat the average for those that do have above-average knowledge! And/or those that continue to do research and create new strategies that incorporate the fact that growing groups of investors don't even look for outperformance anymore.


 1) Passive instead of active is the wrong discussion. Go passive when you don't know how to beat the benchmark. I.e. when you can't find the grandmaster. Just like chess grandmaster would opt for a draw when they don't really like their position and don't know what to do.

 2) When markets are inefficient, the larger the inefficiency, the larger your allocation to a potential grandmaster - or a few of them if you want to avoid putting all your eggs in one basket - has to be. And with Emerging Markets becoming more important in the world, the trend is definitely not one toward a growing necessity for a larger share of 'passive' in your overall, global portfolio.

3) Analyze things on a net basis. If costs are the issue, then why not analyze all strategies after deducting management fees and trading costs from the gross results?

4) Having no success so far with active vis-a-vis passive strategies, basically doesn't change the conclusion that real grandmasters exist. It just leads to the conclusion that your manager selection adviser was no grandmaster in his field.

5) The experience in the chess world indicates that it is possible to define grandmasters. The financial world needs a better rating system.

6) In the end you will end up with a mix of passive and active strategies in a well-diversified good investment portfolio

7) The manager selection process is an ongoing one. It is not just about selecting the winners, but also about kicking them out when they stop performing. Just like in chess: the world champions and top grandmasters of 10-20 years ago are not necessarily the best kids-on-the-block today. You have to continue doing the necessary research.

8) Expected rewards? Top managers can outperform by 3-5 percent on a net basis. But OK, if we assume that you can't pick the winners all the time and once in a while will be simply unlucky, then it is still likely that - if-and-only-if you were fair to yourself and critical in your selection process - you can achieve a net 1-3 percent outperformance on selected active managers.

9) But as we already stated, there will at any point in time be asset classes where you simply don't know how to find the grandmasters. Assuming that you have to go passive in those asset classes, the overall net expected outperformance can be about 1 percent in case you assume a 50-50 active-passive mix.

10) Not important? If your passive mixed portfolio would return 6 percent per annum, this would transform USD 10,000 into USD 17,908 after 10 years. Earning 7 percent instead would lead to an end result of USD 19,672. A nice difference, especially when this 1 percent becomes relatively more important the lower the expected returns are (e.g. like for instance now when interest rates are very low).

11) Still not convinced? Then do also not forget that if the 'go passive' group grows, our initial calculation of 3-5 percent (see point 8) will show a tendency to go upward as a result of which you will be left with more than 1 percent outperformance in step 10.

12) Anything known about manager types when it comes to picking grandmasters? Yes, one thing. Size matters, but it is definitely not true that the bigger asset managers are the best ones.

In other words: keep checking out those ETFs by Vanguard and others, but never ever stop looking for gemstone managers in your Morningstar or other manager databases. And also: don't overestimate yourself. The grandmaster managers are there, but are you also a grandmaster manager selector!


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: The author is an adviser to pension plans in the Netherlands. During the last 10 years he has worked together with Nobel Prize Laureate dr Markowitz on a Modern approach to Modern Portfolio Theory. These reflection are directly embedded in this 'Modern' Modern investment approach.