Management Strategies: Active vs. Passive Approaches
Active hedge fund managers face a number of key challenges in consistently beating passive investment returns. One such challenge is the concentration of returns in large-cap index stocks, making it difficult for active managers to deviate from these and still outperform.
Another challenge is the shift towards low-cost passive investing. As assets migrate into passive, index-based portfolios, active managers are forced to adopt more complex tactics, such as mathematical models, algorithms, derivatives, and hedging, to try to deliver alpha and downside protection.
Structural and cyclical headwinds also pose a significant challenge. The rise of passive management and prolonged low interest rate policies have made generating alpha harder, leading many active managers to "index-hug" without providing significant outperformance, leading to investor outflows.
Long stretches of underperformance are another challenge. Research shows even top active funds may experience 9 to 11 years of underperformance within longer periods, challenging investor patience and conviction.
Opportunity cost and fees are another hurdle. Passive strategies offer market returns at significantly lower fees, so active managers need to justify higher fees by outperforming net of costs. Failure to do so means investors might as well choose passive funds.
Key person and succession risks, difficulty in picking extreme momentum, and the Efficient Market Hypothesis (EMH) further complicate the landscape for active hedge fund managers.
In contrast, Karl Rogers, a focus in the alternative investment industry, takes a different approach. Rogers believes in paying low fees for systematic exposure and only paying performance fees for concentration of both alpha and idiosyncratic exposures with low-no systematic exposure.
Rogers allocates a smaller portion of investments to risks/exposures that can be provided by active managers, such as hedge funds, to help diversify the portfolio and add to the portfolio's return in terms of alpha.
The Arbitrage Pricing Theory (APT) forms the basis of Rogers' approach. APT is a multi-factor pricing model that states an asset's expected return can be predicted using the linear relationship between the asset's expected return and a number of macroeconomic variables that capture systematic risk.
Using APT, alpha is explained as the excess return of the factors, which Rogers aims to achieve through active management in market-neutral/low to no beta strategies. To do this, Rogers invests in passive ETFs that bring exposure to non-market factors like Fama-French's 4 factors and Carhart's momentum factor.
Rogers also uses active management to gain exposure to new or unknown factors that are market-factor neutral. However, he does not invest in 'other' factors beyond market risk, as per the Capital Asset Pricing Model (CAPM).
In summary, while active hedge fund managers must overcome market structural forces favouring passive investing, justify higher fees through consistent alpha generation despite concentrated index returns, manage long periods of underperformance, and mitigate risks unique to active strategies, Karl Rogers takes a different approach. His investment philosophy involves a majority of investments in low-cost passively managed market and factor exposures across different asset classes, with a focus on equity hedge funds as the active management investment vehicle within the alternative investment industry.
[1] Source: "Active vs. Passive Investing: What's the Difference?" Investopedia. [Online]. Available: https://www.investopedia.com/terms/a/activeinvesting.asp. [Accessed: 2022-03-24].
[2] Source: "The Arbitrage Pricing Theory." Investopedia. [Online]. Available: https://www.investopedia.com/terms/a/arbitragepricingtheory.asp. [Accessed: 2022-03-24].
[3] Source: "The Pros and Cons of Active vs. Passive Investing." Investopedia. [Online]. Available: https://www.investopedia.com/articles/investing/081915/pros-and-cons-active-vs-passive-investing.asp. [Accessed: 2022-03-24].
[4] Source: "Efficient Market Hypothesis." Investopedia. [Online]. Available: https://www.investopedia.com/terms/e/efficientmarkethypothesis.asp. [Accessed: 2022-03-24].
[5] Source: "The Role of Active Management in a Low-Volatility World." BlackRock. [Online]. Available: https://www.blackrock.com/corporate/literature/publication/role-of-active-management-in-a-low-volatility-world.pdf. [Accessed: 2022-03-24].
Active management in finance, particularly within hedge funds, is often challenged by the shift towards low-cost passive investing, as assets migrate into passive portfolios, prompting active managers to adopt complex tactics to deliver alpha and downside protection.
In contrast, Karl Rogers, a focus in the alternative investment industry, adopts a different approach, investing primarily in low-cost passively managed market and factor exposures across various asset classes, with a focus on equity hedge funds as the active management investment vehicle within the alternative investment industry.
