How Could Active Portfolio Management Work Today?

Last week  I discussed some of the odds stacked against active management of equity portfolios.  Besides the issues I addressed in that post, active managers have all sorts of other well known headwinds to outperformance: fees, taxes, portfolio turnover and stock selection are just a few of these.  The world also seems to have decided that active management is dead.  All you have to do is witness the explosive growth of ETFs to understand that investors are voting with their dollars and feet towards the active side.

Today though I'm going to do the unthinkable {at least for anything you've read here over the past decade or so} and tell you how I think an active portfolio could outperform a passive one going forward.  My formula is pretty simple formula and I'll lay it out below.

First you have to have a highly researched and concentrated portfolio of names.  Ten would be ideal, twenty stocks would be the ceiling.  You would likely have to actively trade around these positions due to market volatility and be ruthless about paring names that aren't performing if you have something in your research box that you think has better fundamentals.  You would have to mine the portfolio for losses in order to mitigate the effects of capital gains.  Also you would have to be willing to give up some of the profits by hedging the positions, most likely with options or futures.  Finally you would need to have the fortitude to let your winning names run.

Now here's the problem as I see it for most investors and active managers.  They don't have the research capabilities to run that sort of concentrated portfolio and any organization that does isn't likely to bear the cost of having that kind of staff today unless they can also be employed in other forms of investing.  Most won't take the time to do the sort of capital gains mitigation that I think you would need for this to work and most have little to no understanding of the options or futures markets.  Finally my guess is that you could only manage about a $100 million dollars or so in a strategy like this for it to be effective, so I don't think you're going to see a lot of managers scurrying out there to set portfolios like these up today.  Of course this sounds like the original formula that hedge funds used back in the day before they became so huge and it is how many of these rose to the size they have become.  Today though a fund of $100 million wants to get to a billion dollars of assets and the size simply becomes a hurdle that is harder to overcome.

You don't have to worry about me trying to go out and invest this way.  Also I think it would be harder to scale unless done in the limited partnership/hedge fund formate, but if I was going to actively manage a portfolio of equities for clients today, above is the formula that I would use.