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Active To The Core

By: Lawrence G. Babin

A niche style contributes to performance only up to a certain point. After that, things like fees start to take an increasing toll. Lawrence G. Babin, of Victory Capital Management, explains why a core portfolio can offset these.

Most large pension funds have a passively managed ‘core.’ The ‘core’ can be viewed as a remainder – it’s what is left after various portions of the fund have been allocated to specialized investment managers. The ‘core’ portfolio is designed to track an appropriate benchmark while striving to avoid unnecessary fees, risks, and transaction costs.

The rationale for having a core – rather than simply allocating the entire fund to various specialty niche investments – is that a niche style contributes to performance only up to a certain point, beyond which the fees, turnover, and diminishing marginal opportunities associated with niche investments take an increasing toll.

There is no doubt passive investing is one way to manage cost and risk. But is it the best way?

Major Drawback

Passively buying the index has one major drawback. Often without realizing it, an indexer must place big bets on overvalued stocks and sectors. Everyone knows about the tech bubble. From 1990 to 1999, tech stocks increased from under nine per cent of the S&P 500, to more than 30 per cent. When the bubble finally popped, indexers had unintentionally bet the ranch on aggressive growth stocks.

Bubbles, or temporary mis-valuations, are not rare events.

Remember the REIT bubble, the Japan bubble, and various commodity bubbles?

We could also point to bubbly prices for specific stocks. WorldCom lost 98 per cent of its value before it was scrubbed from the index last year. Indexers rode a substantial Enron holding down from $83 per share, to pennies in less than a year. In 2003, the S&P lost 22 per cent of its value, but most of that loss was attributable to 10 per cent of the stocks in the index.

Passive investing is like driving straight down the highway in March and hitting every pothole along the way. Everyone knows that, but not everyone realizes we can swerve to miss the potholes. The drawbacks of passive management can be overcome, but only if they are recognized and actively avoided.

Best Of Both Worlds

So what’s the alternative?

The best of both worlds is to design a portfolio that broadly mirrors the benchmark, but strives to avoid identifiable risks. That is what we mean by ‘active core’ investing.

Needless to say, it isn’t easy. The whole reason for indexing is that active management is much easier said than done.

After doing this for many years, I would say it takes two things to manage an active core process. First, it requires a well-articulated discipline to consistently construct portfolios under all the various market conditions we may face. It is often at the height of a stock market bubble that active managers start to forsake their customary disciplines.

Second, an active core process requires a lot of people, both to manage the day-today buying and selling of a broadly diversified equity portfolio, and also to spot the shifting risks and rewards across a wide spectrum of financial markets.

The goal of an active core process, first and foremost, is to protect against downside risk.

Hitting Potholes

Hitting potholes is what spoils longterm results. You can’t avoid risk if you want superior performance – but you can try to control risk by maintaining a broadly diversified portfolio and basing buy and sell decisions on thorough fundamental analysis.

The point of a diversification discipline is to force an investor to look everywhere, all across the market. That avoids the trap, inherent in many investment styles, of focusing on too few stocks and sectors. An active core process is not about buying specific stocks with hot stories; it’s about constructing a sound portfolio.

It’s like making stew. A great stew has good ingredients, but what counts is the taste of the stew, not the specific ingredients. The specific recipe is less important than not using bad ingredients, and not letting any one ingredient steal the show. The stocks to avoid are those that will have trouble keeping up with investor expectations.

Good research is the best early warning system.

Lawrence G. Babin is senior portfolio manager at Victory Capital Management.

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