What is Active Management

8 mintues to read (but worth it!)


What is Active Management?


Active management is one of the newer and potentially most costly forms of portfolio management to hit the finance management scene in a long time.

I know this sounds fairly negative but bear with me awhile as I explain why I feel this way.


"Several studies have been conducted to compare actively managed account performance versus passively managed accounts.

When all costs were factored in actively managed accounts did not outperform passively managed accounts over time."

- see the Morningstar Active/Passive Barometer Report for more info. It's updated semi-annually.


Let me explain how an account becomes an actively managed account.

First, the client signs an investment advisor contract.

Then control of the original account is transferred to the Active Manager(AM).

The AM then liquidates all of the current positions into cash.

The next step is to purchase on average about 50 stock and bond positions at a mix based on the client's age and risk/reward preferences.

Each asset position is set up with Good Till Cancel (GTC) orders to protect any down side price movement.

If a position is sold or stopped out because of downward movement, it converts to cash.

That cash amount is usually used to buy back into the position if it moves up a percentage amount.

Sounds pretty simple right?

Automatic orders to get out and get back in.

Now lets dig into the details...


How you're lured in unknowingly

In many cases you're not even told your account is going to be subjected to this form of portfolio management.

It slips under the disclosure laws for investment advisors and clients.

In a general sense, this means it is not required to tell the client how their money will be managed.

When you sign your investment advisor agreement, you usually give them discretionary trading authority.

What is discretionary trading authority?

It is a signed agreement between the client and the investment advisor/broker-dealer firm.

After it is signed, it allows an investment advisor to direct a broker dealer to buy and sell securities without the client's consent for each trade in the client's account.

After you sign that agreement, commissions can be racked up against your account without your knowledge.

A discretionary trading agreement isn't a terrible idea.

Sometimes in a volatile market, it is better for your advisor to make some tactical adjustments, once in awhile.

However, you may want to AVOID active managers making monthly securities purchases and sales to generate sales commissions.

When an active manager has discretionary trading authority pay careful attention to how much you're paying in monthly commissions.

That amount will not be disclosed...


From a recent phone conversation with a large, national brokerage:

"We don't have the commissions you're paying listed. You'll have to go through your brokerage statement and calculate that amount yourself." - customer service agent.


How to spot an Active Manager

They will usually say things in their sales pitch/dinner seminar loosely hinting that they're active managers.

Hope and fear are the two biggest emotions that they'll try to evoke.

Listen for key phrases like:

  • "We're stock pickers." Meaning we’ll pick though an index and select only the best based on our stock selection criteria. This infers that they can perform better than just buying the index outright.
  • "We're not hold and hopers."
  • "We protect every position with trailing stop losses." (More on that later)
  • "If your account takes a large drawdown, you're probably not young enough to see it recover, we're focused on protecting your assets by moving you out of the way of big market corrections at the right time."

Their sales pitch will usuaully evolve around presenting complex investing material.

That presentation is designed to establish them as investment experts in your mind.

As an established expert, they then hint that perhaps they can help you "beat the market."

Then they try to gain your trust and have you sign control of your account over.


The Good, Bad and Ugly of Active Management

What are the disadvantages of active management?

Let's start with an real example of a person that was subjected to active management without her even knowing about it.

A recent widower walked into a large well known brokerage firm to notify them of her husband's passing.

She was there to verify beneficiary rights, reset her password, etc.

She soon walked out of the meeting having signed an Investment Advisor Agreement with a discretionary trading authority addendum.

I'm guessing she didn’t bother to read the 13 page, fine print contract she signed either.

The account balance was roughly $500,000.

Her spouse had managed the account for their entire 50+ years of marriage.

He had held fast to four positions of three ETF index funds and one Mutual Bond fund.

However, he mistakenly never bothered to teach her about his investing style.


Roll the clock forward a month and she asks me to review the first monthly statement.

Here’s what I found:

  • 90 big cap equity positions
  • 30 bond positions.

She now went from holding 4 positions to 120!

She was also invested 60% in equities and 40% in bonds.

Not sure who approved that mix but in my opinion that is completely unsuitable for a women at her age of 75.


So let's breakdown the difference between the account before and after from a potential commission standpoint:

BEFORE

  • Commission possibility
    • Zero, since they were long term buy-and-hold positions
  • 4 longer term positions
  • Reinvesting dividends automatically


Before I evaluate the new account's commission possibilities,

I need to explain turnover ratio.

That’s the average of how many times an individual positions gets traded per year.

The average turnover ratio for actively traded stocks is 250%.

That’s 2.5 trades per position/year!

AFTER

90 Stock positions x 2.5 turnover ratio = Annual amount of trades

90 x 2.5 = 225 trades

------------------------------------------------------

30 Bond positions x 2.5 turnover ratio = Annual amount of trades

30 x 2.5 = 75 trades

------------------------------------------------------
So summing this part up, the account went from 0 trades per year to 300.


Who pays for all of those trades?
YOU DO.

Who’s the big winner here?
THE BROKERAGE.


What’s in it for the Active Management(AM) firm?

Active management dinner

Well to start with, the brokerage will refer many of their high and mid net worth clients to free financial seminars held by the active management firms of their choice.

Of course a nice free dinner and drinks accompany these seminars.

At this point I must own up to having went to many of these free dinners and drinks seminars just for the food and essentially a free night out with my wife, when I was an engineer.

These dinner seminars drive up the Active Managers (AM) Assets Under Management (AUM) total and grow their management business.


Also in some cases the AM will markup commission costs since a professional is making trades for you.
So let's go back to commission costs:

BEFORE

4 long term positions = $0.00 in annual commissions

--------------------------------------------

AFTER

300 Stock/bond trades x $7.00(commissions) = $2,100.00 (!) in annual commissions

--------------------------------------------


That’s a $2,100 dollar a year commission cost difference...

While still charging an assets under management fee!


Another way investors get taken by AMs

Now let's look at another interesting fact of the way this account is being managed.

Most of the positions are positioned with a trailing stop loss.

These will sell the position at market if the position reverses by whatever the stop loss percentage is set to.

Here's an example:

Buy XYZ at $75 and after filling the position set up a 5% stop loss order.

If the price runs up to $105 the stop loss would let it run as long as there were no 5% drop backs along the way.

But if XYZ suddenly reverses to $99,

Your stop order would get triggered at $100.

It would sell XYZ at market as it dropped through $100.

So this technique is pretty good, it lets your winners run and it gets you out on any drawbacks.

Sounds like a smart strategy right?

Here’s where the problems for you occur.

You're not in control of the stop loss percentage set on each position, the active manager is.

The tighter the percentage the more the position will be traded.

With a 2% stop loss percentage, the position could be traded almost weekly because of normal market oscillations.

A ten percent stop loss percentage may go a year without being triggered.

Can you see the potential for abuse here?

The stop loss positions for stocks and bonds don’t have to be the same percentage either.

In fact, the bond positions should have a tighter stop (say 2%) versus stocks at 5%.


Now let’s examine a very suspicious set up for the account I mentioned previously.

Remember this person is 75 years old.

Classic risk management percentage would have this person in no more that 35% market and 65% bonds and even less market exposure for a more conservative investor.

Remember this person was set up for 60% market and 40% bonds by their new advisor/active manager.

That’s 25% too high of a market exposure for an average investor at that age. (Unless the client wanted that type of risk exposure and signed an agreement stating that they understod the risks)

Why would they do this?

It’s doubtful the investor told the IA to be more aggressive than normal.

So, this takes me back to the by now famous or tired of hearing about the Trailing Stop Loss Percentage order(TSLPO).

Which type of asset position do you think would get set off more by market volatility therefore driving up commissions?


Stock positions or Bond positions?

Well the answer is simple...

stock positions.

Oh and this person has 90 of them versus 30 bond positions.

Is it possible her portfolio was setup unsuitably, for someone her age, in order for the AM to profit off higher trade volume and therefore, commissions?

Here’s another interesting fact about the account.

The 90 stock positions were all Big Cap stocks.

The 30 Bond positions were almost all intermediate bond positions from different ETF and mutual fund companies.

These 120 positions could be covered by TWO ETF purchases:

  1. a BIG CAP ETF
  2. an Intermediate term Bond ETF.

What would generate more commission income?

Opening and mananging 120 positions or 2?

You be the judge.


The last subject on this topic is the TSLPO.

It’s fairly easy to set this order and let the market run with it.

The difficulty is when to get back in the market once your stopped out in cash.

The active manager doesn't really care about this dilemma since more trades creates more profits.

For the individual investor you have to consider several scenarios:

  • "Is this a bear trap and as soon as I get in, is it going to continue down?"
  • "Am I catching a falling knife or should I let it drop further? "
  • "Am I going to miss the rally up from here?"

Dow Jones Industrials 09/2018 to mid December 2018

Look at the chart above.

Here’s a recent example of this dilemma.

It’s the Dow Jones Industrials mid September to mid December 2018.

With a 3% trailing stop to exit or enter your positions, you would have made seven trades in a 3 month period.

You would have lost 3 % on each of the four down legs or 12% and potentially gained some of it back, buying into the subsequent up move.

Now remember this is the Dow but she was holding 90 big caps which tend to move very closely to the Dow Jones Industrial average.

So seven trades times 90 positions would cost you 630 trades times $7 per trade or 4,410 plus overall

You're still down on your stock positions too.

Active position management can work OK in a slow gradual moving market but becomes very expensive and troublesome in a choppy market.


To sum up active management of your account, here’s what you're going to get:

  • High commission costs
  • Limited downside protection
  • Potential unbalanced Market/Bond percentage exposure

I hope this paper met its goal which was to educate you on the inner workings of active management.

I hope it supported my original statement that active management style of portfolio management is great for brokerages, good for active managers and not so good for you.

Don’t get me wrong; I am not saying all active managers are using these techniques in their clients' portfolios.

However, we have seen these practices in several of the portfolios we've examined.

It’s up to you to look into your account and see if any of these behaviors are occurring.

Take the advice of one of the greatest investors or our time Warren Buffet.

Try to set your portfolio up with a mix of low net expense ratio ETFs, one broad market, one bond at a percentage mix to your comfort level.

Then go really long.

Thanks for your time.


Would you like me to check out your accounts to see if you're getting actively managed?

Give me a call at (949) 370-3379

or

send me an email at

jferraro@longhouseinvestments.com

and let's take a look together.

You might be surprised at what I find.