On January 30, Matt Zenz of Dimensional Fund Advisors hosted “What Might the Future of Active Management Look Like.” The event was the first in this semester’s Robert K. Wilmouth Speaker Series, a number of lectures hosted by NDIGI designed to further students’ knowledge of the science and art of investing.The objective of the event was to demonstrate to students the differences between active and passive portfolio management, the structural tensions between the two, and the more neutral philosophy of Dimensional Fund Advisors.
Zenz, a Notre Dame alum, has been a portfolio manager with Dimensional since September of 2017. He previously worked as an engineer with General Electric before deciding to pursue a career in investing, earning his MBA from Harvard Business School in 2015.
Active Management
Active management is a portfolio management strategy in which a manager examines multiple securities and personally chooses which to invest in. They “look at their universe of securities,” said Zenz, “evaluate them in different ways, find the ones they think are undervalued, and buy. They then find the ones they think are overvalued, and sell.” The aim of an active manager is to outperform an investment benchmark index, such as the S&P 500 or the Nasdaq 100. Some of the advantages of active management are that investors have the potential for market-beating returns, and they are not tied to any particular industry or index.
There are some drawbacks associated with active management. Due to the notoriously volatile nature of the market, the selection of stocks by the portfolio manager can often be a difficult task. Because of the high fees associated with active management, it may also be difficult for some investors to outperform their index benchmark.
Passive Management
Passive (also known as index) management is a strategy in which portfolio managers are not trying to beat, but instead mirror, a market index. It is associated with mutual and exchange-traded funds (ETFs). A passive manager will essentially “draw a line” on an index list. This is known as the index’s target range. Over time, securities will move in and out of this target range. When they reach a price above this line, the passive manager will sell the security and reinvest the earnings in a stock within the range. Passive management is typically associated with extremely low fees and minimal commission charges. It is also easy for investors to remove and reinvest their earnings at any time.
The largest disadvantage of passive management is that index funds must be bought on the “day of rebalance” at 4:00 PM when the market closes and the index rebalances. Equity traders are aware of this and will charge investors a high premium to buy securities. This results in a lower average equity premium.
Is There a Different Way to Invest?
Traditionally, investors have examined the advantages and disadvantages associated with active and passive investing and chosen one of the two for their portfolio management. Matt Zenz and Dimensional Fund Advisors, however, believe they have produced a new philosophy, one that incorporates both active and passive techniques, that may better suit certain investors.
Approach at Dimensional Fund Advisors
Dimensional practices what they call “factor investing.” They do not assume that a security is overvalued or undervalued, but that its price instead reflects the aggregate expectation of market participants. Using this market-determined information, as well as a security's book equity, Dimensional finds the discount rate of a security and uses this as the expected return on investment for their clients.
Because of the difficulty often associated with predicting the market, Dimensional believes in investing in long-term premiums. Zenz stated that “In stocks, the data can be very noisy, and you need to look over a long period to time to see trends.” In fact, Dimensional will look back at data as far as it goes. In some cases, this means the fund examines market information over periods of 90 years or more.
The Triangle of Trading
Zenz spoke of what he termed the “triangle of trading,” the three hallmarks of investing that are price, quantity, and time. It is nearly impossible, he stated, for an investment manager to acquire all three at the same time. He or she must always sacrifice one of the three. Active managers will sacrifice price. They are typically willing to pay more for a stock, as long as they believe it is still priced below their valuation. Passive managers are willing to sacrifice price as well, because they have to buy and sell securities at a specific time.
Managers at Dimensional, conversely, focus solely on price and are willing to sacrifice both quantity and time. They believe that so long as companies have similar factors, they will have similar expected returns. Traders at Dimensional, then, have the flexibility and authority to buy any stock with the same expected returns as another.