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Behavioral Matters:
Insights from the application of Behavioral Finance

Issue 41
February 28, 2017

Behavioral Matters is a series of essays on the application of Behavioral Finance written specifically for professional investors and portfolio managers.
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Beware Passive Investing

"Nobody is going to save you but yourself and the best and only way to do so is through action."
-Oli Anderson

Active management is tough business. Once alpha-generating strategies can lose their luster in a quarter or two, helping to explain why 4/5 of active funds underperform each year. The challenges facing active management — particularly the competitive threat of passive products — have never been greater. In response, traditional investment management companies have launched a host of initiatives to fortify their businesses including: creating custom portfolios to match unique client requirements, establishing their own index and ETF offerings and revamping marketing/customer relationship services. Less frequently observed are concerted efforts directed at improving skills, processes and ultimately performance: not improvement as an aspirational goal as it is generally approached, but improving deliberately using rigorous feedback and a scientific method. This essay takes a hard-nosed look at the pummeling being taken by active management and argues that improving can no longer be approached passively and that it must become a core competency for every active manager.


The global shift in assets away from active to passive products, while already substantial, is about to hit its full stride, according to Moody's Investor Services. In a recent report, they state: "Passive investments – ETFs and index funds – account for $6 trillion of global assets. Now 28.5% of assets under management (AUM) in the US, their US market share is rapidly expanding, driven by lower cost and better performance relative to actively managed funds." Moody's goes on to project that within the U.S. passively managed assets will exceed those actively managed sometime between 2021 and 2024. They further estimate that between 5%-15% of assets in Europe and Asia are managed passively today but expect this proportion to grow significantly in the near-term.

Moody's believes this capital reallocation reflects, in large part, investors reassessing their options: "The main driver of flows out of active funds into passive funds has been investors' growing awareness that, by definition, actively managed investments, in aggregate, cannot deliver above average performance, and that investing is therefore a zero-sum game – for every winner, there must be a loser(s)." An additional driver cited is changing regulations: "Passive investments' expansion has been further supported by global financial regulation, which has encouraged greater disclosures of fund fees and potential conflicts of interest." The report adds: "In practice, it will become more difficult for advisors to place their clients into higher cost and more complex investment products." All of which will impact asset aggregation the report concludes: "Selling low-fee index products, on the other hand, will eliminate many apparent conflicts of interests and minimize an advisor's fiduciary risk."

Structural Shortcomings

Active management is ill equipped to achieve meaningful improvement currently due to the heavy dependence upon folklore and poor feedback to support learning. Expressions of folklore recited routinely include: it is a good sell as long as the proceeds are reinvested in a winning buy; growth managers are more likely to exhibit the endowment effect; and managers that beat their benchmarks do so primarily by purchasing great names. Comforting as these and other investment truisms feel they are often wrong, as borne out by Cabot's analysis of more than $2 trillion of professionally managed assets.3 Reliance on such pseudo-facts gives individuals a false sense of their own strengths and shortcomings, making it near-impossible to improve.

Poor feedback is what inhibits self-awareness and improving. What type of feedback specifically? All of it! Conventional metrics such as: relative return, information ratio, tracking error, alpha, attribution analysis and hit rates are merely scorecards. They provide useful information about past performance yet they say nothing about the manager's strengths and weaknesses.4 Most importantly, they cannot guide the manager to the one thing she should do today to become a better investor tomorrow. Improving requires facts not hunches, and needs to be driven by rigorous analytics not emotionally laden recollections or reliance on comforting narratives.

Numbers You Can Count On

How do you generate most of your portfolio's performance, from buying or selling? The answer probably came to you before you finished reading the prior sentence. But how do you know? You can't, not for sure. Knowing implies the availability of data-driven facts such as: my buying generates over 175 basis points of relative return annually while my selling, which used to cost the portfolio 225 basis points, is now neutral. Lacking rigorous feedback like this you're just guessing. And as the Moody's report makes clear — guessing ain't getting it done.

Fortunately, a new analytic framework that supports learning and improving now exists. The new framework enables you to quantify skills, processes and behavioral tendencies. Armed with this clear feedback you can set about becoming self-aware and improving deliberately. This framework is being used by hundreds of professional investors around the globe and the results are impressive. Portfolios engaged in deliberate improvement are, on average, adding approximately 45 basis points of incremental relative return year after year.5 These managers are using their processes to do more of what they do well, to improve where needed, and to eliminate unproductive behavioral tendencies.

The analytic framework and how it supports improving are fully described in: "Managing Equity Portfolios: A Behavioral Approach To Improving Skills and Investment Processes," by Michael Ervolini, MIT Press. Mike's book also includes seven ideas or projects that will allow you to begin improving deliberately right now.


Passive investing is now hitting its stride and soon will be lapping active management in the US and the same is expected throughout Europe and Asia in the not-too-distant future. As Moody's explains it: "Investors will continue to shift to beta investments, whether smart, simple or exotic, given their lower costs, better performance and transparency." In light of this assessment, approaching business as usual will, for a number of management companies, likely segue into "out of business."

In contrast to the troublesome asset reallocation occurring, improving how well you invest is completely within your control. There is plenty of evidence to suggest that if you approach improving passively you are all but doomed to deliver passive results, or less. There is no sensible argument for not wanting to do your best for your clients and that can be achieved only through deliberate improvement. Of course, actively engaging in deliberate improvement may not assure you a place on "the stairway to heaven" but taking a passive approach to becoming a better investor will surely result in a terminal case of the "Moody blues."


1. Anderson, Oli, "Personal Revolutions: A Short Course in Realness," CreateSpace Publishing, 2016.

2. Moody's Investor Services, "Passive Market Share to Overtake Active in the US No Later than 2024," February 2, 2017.

3. Buying and selling should, in fact, be evaluated separately which leads to a good sell being one where the position sold goes on to underperform the manager's portfolio. The endowment effect or holding onto winners too long is found in every type of portfolio (i.e., growth, value, core, benchmark agnostic, etc.). Many successful managers derive most if not all their excess return from strong selling and/or position sizing, often in conjunction with neutral or negative buy skills.

4. A more expansive discussion on this topic can be found in Chapter 2 of "Managing Equity Portfolios, A Behavioral Approach to Improving Skills and Investment Processes," by Michael A. Ervolini, MIT Press, 2014.

5. Based on a study of over 80 professionally managed portfolios across a five-year timeframe. For more information see: "Improving Deliberately with Cabot", available from Cabot Research LLC.