The road from 0 to 1
There is only one lasting alternative to creating something the world has already seen. Create something that is truly different. This isn’t an easy path particularly in the asset management business. It is the much harder choice.
Why?
Because something that is truly different than what exists today will have a large deviation from the standard industry benchmarks. Most active managers hug their benchmarks closely for a reason: investors have a very low tolerance for anything that deviates from the norm on the downside. When I say low tolerance I mean they will start redeeming if there is a 6-12 month period of underperformance, and if there is anything longer the floodgates will open.
Therein lies the problem, because even the best strategies will have many, many periods of underperformance over 1 to 3 year time periods. And if those periods of underperformance happen to come early in the life of a fund/strategy, it may not live to see the other side.
But it is a problem and risk that is unavoidable if you want to go from 0 to 1. For in order to have a chance of beating the market average, you have to look different than the average. And looking different means there will be times when the market average looks great and you look terrible. There is no other way.
What does that mean in practice for active investors?
The Vanguard Value ETFs (VTV – Large, VBR – Small) have an expense ratio of .08%. If you are a large/small value manager charging premium fees, you will need to beat these funds after expenses in order to compete in the new world order. The only way to do that is to look different.
The iShares MSCI USA Momentum Factor ETF (MTUM) has an expense ratio of .15%. If you are a momentum manager charging premium fees, you will need to beat this fund after expenses in order to compete. The only way to do that is to look different.
The newly issued Deutsche X-trackers USD High Yield Corporate Bond ETF (HYLB) has an expense ratio of 0.25%, half of the leading ETF in the space (HYG). If you are a high yield bond manager charging premium fees, you will need to beat this fund after expenses in order to compete. The only way to do that: look different.
In looking different, you still might not beat these passive products (the odds are stacked against you as any academic study will tell you), but at least you have a fighting chance. The active managers that hug their benchmarks and charge premium fees have no chance. The passive managers slicing and dicing passive indices, fighting each other to the death for basis points, will eventually drive economic profits in that space to nothing.
From 1 to n or from 0 to 1?
The choice is yours.