The Con of Passive Management

The passive management industry has done an incredible job of projecting their mantra into the investing zeitgeist, and each year we are subjected to claims like “74% of active managers underperformed their index.” Like all good cons, this is not an untrue statement. It is however, an excellent use of misdirection – making implications about passive strategies that are untrue.

“If that many active managers underperform, I guess I’ll just go passive.” This is the inference that the passive industry seeks from the world, and sadly one that the uncritical investor has fallen prey to. The following is not a rejection of passive strategies, but a few thoughts on how to more accurately consider the active vs. passive debate.

Let’s start with an obvious point. It may be the case that 74% of active managers underperform their index in a given year, but what is left unsaid is that if all passive managers are doing their best to follow their investment policy, 100% of them will underperform! Why? Investment strategy returns can be reduced to a reasonably simple equation:

Strategy Return = Market Exposure + Alpha – Fees

So if your alpha is 0% (all passive strategies), and your fees are > $0 (all businesses), then your returns are lower than what pure market exposure would produce. 100% of passive strategies should underperform their indices. 74% isn’t great, but it’s better than 100%.

OVERSIMPLIFIED

Passive managers are well aware that active managers’ returns are a product of their market exposure (Beta), and their skill (Alpha). The fact that the passive industry continues with the ruse of comparing all active managers to a non-risk-adjusted performance figure is deplorable, because it confuses most investors.

Most active managers run less risky portfolios than their index or benchmark. Asset management is risk management, and prudent risk reduction should not be penalized. When sophisticated investors compare managers, they compare risk-adjusted returns. The only way we should be determining an active manager’s value is by measuring alpha generation.

ZERO SUM GAME

Alpha does not exist in nature. If alpha is created in one manager’s portfolio, it necessarily means that another manager has generated negative alpha. Picking the manager that can generate long-term alpha isn’t a trivial exercise, but it is certainly worth the effort considering the impact that the power of compounding over decades has. Even if there is no alpha on average, there are many managers who generate it.

You wouldn’t stop watching the NFL and say, “Another terrible year, on average the league was just.500, again.”

So when is an active manager worthy? Don’t compare returns to an index, compare alpha to expenses. If an active manager generates more alpha than they charge in fees, they are worthwhile. In fact, it is a little easier than that, because the next best alternative to a good manager, indexing, has some costs. So a manager is worthwhile in practice as long as their alpha, less their expenses, is greater than the -10bps associated with passive management fees.

It is more work to analyze managers under this far more accurate framework, but it is absolutely worth the effort. Passive investors are certainly better than active managers’ whose fees exceed their alpha – I just wish they would say that instead of perpetuating their con.

The Problem With Offshore Banks

“What’s the best way to rob a bank? Start one.”

Many people have heard that old saw. But it’s no longer accurate. The best way to rob a bank is to control a government… any old government will do these days.

It wasn’t always like that. You see, for most of modern history, governments knew to keep their hands off banks. Whether led by kings, prime ministers, presidents or dictators, states understood that the first time they raided a private bank for loot would be the last. Bankers would close up shop and go somewhere else, and the next time the rulers needed to borrow some cash, there would be no lenders left in town.

My, how times have changed! Not only do modern governments feel perfectly free to steal from local banks or from offshore banks… they actively compete with each other to do so.

Guilty as Not Charged

It’s more important than ever to be choosy when picking an offshore bank.

A few weeks ago, the government of Honduras seized the property of one of the country’s leading businessmen – including the bank his family owned. The bank was liquidated, leaving over 200,000 local and foreign clients in the lurch.

Seizures and forced liquidations aren’t uncommon, of course. Courts all over the world order such things all the time when individuals or organizations are convicted of crimes. What made the Honduran case unusual is that there was no court, no trial and no crime.

You see, a relative of the Honduran businessman in question had been arrested in the U.S., where extrajudicial asset forfeiture is practiced.

In the Land of the Free, federal, state and local authorities can and do seize all sorts of property on just about any pretext, simply by asserting that the property (a car, a house, a farm, cash, etc.) is somehow associated with a crime. They don’t have to prove this – their own say-so is all they need. The owner of the seized property doesn’t have to be guilty of anything, or even be charged with a crime. Instead, he or she has to prove that the property isn’t “guilty.” Most of these owners never manage to come up with the money, time or other resources needed to do so. So they lose their property, which is usually sold for profit or used by the government.

Get While the Gettin’s Good

Knowing this, the Honduran government reasoned that it was likely that property in the U.S. belonging to the Honduran businessman’s family would be seized by the U.S. authorities. They concluded that if this happened, the businessman’s local bank might not be able to meet its commitments, angering a lot of local depositors who are also voters (or government officials).

So to get a jump on the process, so to speak, the Honduran government seized the bank before the U.S. government could get their hands on related property. It was a preemptive raid, not based on any proven violation of Honduran or U.S. law, but rather on the knowledge that if they didn’t act first, the Yankees would. It’s like a scene in a Western movie where one set of robbers races another to catch up with the stagecoach.

You might think this is a sui generis case, shaped by the U.S.’ peculiar asset forfeiture practices. Maybe so… but the underlying logic behind Honduras’ action has recently been globalized.

One Global Tax System, But Many Governments

Here’s why: The G-20 recently adopted a global financial-information-exchange protocol, inspired by the U.S.’ Foreign Account Tax Compliance Act (FATCA). Over the next few years, financial institutions everywhere will be sucked into a web of reporting designed to ensure that nobody can keep money secret from any government. Whether they like it or not, banks will have to hand over client information to their own governments, who will then share it with others.

It’s easy to see how that will make tax enforcement easier. But it may also result in some nasty unintended consequences along the lines of the Honduras case.

If the G-20 data-sharing plan works as planned, government officials everywhere will be able to monitor changes in the offshore financial holdings of local individuals or businesses. This sort of intelligence could trigger precisely the sort of preemptive strikes that took place in Honduras. A big local business is losing money in its overseas operations? Better grab its local assets now, before a foreign court can seize them as part of a bankruptcy proceeding. Ditto for individuals.

The bottom line here is that, as always, government action – the G-20 reporting web – will create a new set of incentives that will have unpredictable consequences. The only thing we can be sure of is that government will look after its interests… not yours.

The world of offshore banks is becoming more complex. That’s why it is absolutely critical that you have an inside guide to the most recent developments… so you can stay one step ahead of the government thieves.

Investing Portfolio Types and Portfolio Diversification

The financial goals, investing skills and risk-tolerances are different among people. That is why everyone needs a personalized investment portfolio that address their needs, skills and resources. Based on the diversification and investment instruments, a portfolio can be grouped in to one of the five major portfolio types.

1. Defensive Portfolio: The diversification includes investing a majority of the money in low-risk investments. The investors look for long-term price accumulations rather than for quick returns. The common instruments include stock of blue-chip and growing companies, treasury deposits and bonds, commodities, precious metals, etc. Instruments with high-volatility and low-liquidity are generally avoided. The strategy requires good initial research, but less real-time management. Although the returns can be lower, the investors can avoid huge losses.

2. Aggressive Portfolio: This includes investing a major part of money in high-return, but high-risk investment products. Generally investors look for short-term profiting opportunities. The major investing options include stocks of all kinds, Forex currencies, funds and bonds, commodities, futures, indexes, real-estate, etc. The strategy requires an active real-time portfolio management, good money management and risk management skills. Also, the investors require good technical and fundamental analysis skills, software support and related trading infrastructure. Aggressive portfolio management can offer better returns, but there is also high risk of losses.

3. Income Portfolio: As the name suggest, the portfolio management involves investing in products that offer constant returns. Most of these returns can be fixed too. These returns usually involve interest on money investments, returns from bonds and funds, dividend from stocks and shares, or price appreciation on precious metals or commodities. The strategy requires good initial screening and involves lowest downside risk of all portfolio types mentioned here. The returns can also be lowest, but constant.

4. Speculative Portfolio: This is the portfolio type which requires most active management and involves investing in high-volatile high-risk and high-return financial products. This also includes investing with burrowed money and going against existing trends. The common investing instruments include stocks of new and small companies, IPOs, options, futures, currency pairs and on emerging markets. Investors should be extremely dedicated with good investment skills and resources. The returns can be very high, but there is no guarantee.

5. Hybrid Portfolio: These are portfolios with very good diversification to include more than one type of financial instrument. Based on the diversification the portfolio can be slightly more aggressive or defensive. Investors can also choose to include different return investments and to close existing investments according to their returns, changing economy and investment skills.