Yesterday I picked up a book by Grinold & Kahn called “Active Portfolio Management: A Quantitative Approach For Providing Superior Returns And Controlling Risk”. I don’t propose to review this book here because it’s primarily designed for investment professionals, and you can say it’s cutting edge and hence extremely complex (and I will probably take the better part of a year to properly read through it and even get close to understanding it properly).

However something in there tweaked in my mind which I’d like to share here. Essentially it’s to do with how one should quantify and measure outperformance. For instance, when you meet someone who claims to be able to beat the market, and he can prove that he did so for 1 or 2 years straight, how can you tell that it’s not just luck? Simple as this question seems, it’s extremely hard to measure. This brings up the question of what exactly is outperformance and do we really understand what it means. Those who claim to be able to do it consistently, are called “active investors” and those who don’t are called “passive investors”.

Passive investors either don’t believe that it’s possible or can’t beat their benchmarks and recommend spreading your investments out into assets which diversify your risks to the extent that for every unit of risk you take on, you get the maximum return. This process of minimising your risk whilst maximising returns is a scientific process involving analysing the performance of each asset and measuring how they behave in relation to one another, and then choosing the combination of assets which behave in such a way that their movements cancel each other out to the extent that the performance of the entire portfolio will not be as susceptible to market movements and general downturns. Great, but that also means that upside is limited - which is why most investors, although they accept that passive investing is fundamentally the safe route to take and historically proven to be the only real way of consistently making money, know also that it ain’t going to make them millionaires overnight. But since it’s the most “correct” way to trade, it’s something that every portfolio manager is aware of, and an approach which this site advises.

But as I said, because of the dissatisfaction that portfolio managers have with this theory a lot of work has been going into the area of “active investing” and over the next year I will be looking into some of these techniques in a little more detail and sharing what I can. These methods are typically unproven, and even Grinold & Kahn’s book doesn’t claim to provide any active investing techniques itself, but only lays out the groundwork for how one can develop and properly measure such a system.

In short, the message that hit me in relation to all this is the realisation that when someone claims to be able to outperform, he is telling you that he is beating passive investors, and so he is enriching himself even more with an amount which represents the difference between his performance and the performance of a passive investor (typically referred to as “Alpha”). Where does this extra money come from? Since there is only a finite amount of money in the market, it really means that he has taken it from another investor. So here’s the moral of the story - if you think that you can or have a system to beat the performance of a benchmark like the KLCI year in year out consistently, then you are betting against other people and coming out a winner more often than you lose. In otherwords, there is a greater fool out there than you.

For me this is quite a humbling proposition since pretty much all the investors I know are smart people who made their own money to play with. And like I said in previous posts, the challenge in the Malaysian market is that apart from equities, there really isn’t much else to play with like bonds or ETFs. Therefore it is hard enough to be a passive investor and develop a portfolio which does not have a great deal of correlation with the market. Which is why most of us end up chasing alpha and risk becoming the greater fool.