Excerpt of column published by Christopher Joye in The Australian Financial Review

At a seminar this week I was asked to define what we mean by “active” management. Start with the alternative: passive investing or blindly following market indices is by design price- or valuation-agnostic capital allocation (given the assumption markets are generally right or “efficient”). Irrespective of how overvalued or undervalued an asset class may be, the passive portfolio accepts exposure to it. The active player, by contrast, seeks to outperform market benchmarks by identifying irregular pricing errors – typically individual assets that the market is undervaluing and which can provide additional capital gains if and when prices converge back to fair value.

The challenge is that the active investor is pitting his or her analytical prowess against the collective wisdom of markets. While this is theoretically hard to do in efficient and transparent sectors like listed equities, it should be easier in darker and more opaque places like residential housing, private equity and over-the-counter bonds.

Active managers ideally want to operate in markets where most buyers and sellers have imperfect information about day-to-day valuation movements, which makes it difficult to accurately price idiosyncratic assets. In technical terms, the active investor is seeking to produce “alpha”, which I define as excess returns above those earned by mindlessly taking on risk factors (aka “beta”).

In property the latter is akin to gambling on off-the-plan developments, which come with greater probabilities of loss. In private equity it might involve investing in early-stage companies with higher failure rates. And in fixed income, it is like chasing more attractive interest rates in high-yield assets (eg, hybrids or junk bonds).

The true active manager produces excess returns that are attributable to valuation skill rather than these risk factors.

All of this is naturally easier said than done. Global macro hedge funds were clamouring to claim that the heightened volatility in late 2014 would finally present them with a target-rich opportunity set that would liberate superior returns. And yet most have performed poorly because of their inability to divine the capricious public policy perturbations that pollute asset prices.

Few, if any, expected a 1.75 per cent RBA cash rate years ago or predicted that central banks would be buying billions of dollars of corporate bonds in 2016.

Within the active space it is much harder to add value through isolating mispricings in risk-free rates (driven by macroeconomic events) because, as the RBA’s confidence intervals highlight, these are inherently unpredictable.

Currencies and interest-rate derivatives are also some of the most heavily traded and efficient markets you will find, given they are contested by every bank, hedge fund and fixed-income punter on earth. It is easier to extract alpha in poorly researched sectors characterised by high levels of asymmetric information, like small-cap equities.

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