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“Have you sold out?” That was the half-joking response of a friend when I told him I was consulting with L2 Asset Management, an active fund manager.
I have been (and remain) a passionate advocate for index-based investing for over two decades. I wrote The Smartest Investment Book You’ll Ever Read in 2006. In that book (and in five subsequent ones and hundreds of articles), I distilled sound investing to three index funds from low-cost providers like Vanguard.
For many investors, market-cap weighted index funds deliver inexpensive beta and are a valuable resource.
Why then would I work to increase the profile of an active fund manager? My reasons reflect the increasing pressure on advisors to differentiate themselves and demonstrate value. They also illustrate the blurred line between “active” and “passive” fund managers.
What is active?
The line between active and passive management is no longer binary. According to this thoughtful article from Dimensional Funds, “Evolution of the investment landscape has rendered binary active/passive labels outdated for comprehensively describing an investment strategy’s approach.”
Funds that engage in stock picking and market timing are clearly active.
Funds that track a broad-based, highly diversified index are clearly passive.
What about well-known fund managers like Dimensional, AQR and Blackrock? These fund families offer funds that screen for factors, identify market segments with higher expected returns, consider market liquidity, avoid stocks with certain characteristics or engage in flexible trading to reduce costs, using processes that are informed by credible evidence in peer-reviewed journals?
Their process is systematic and replicable. They implement it without judgment.
Can they be categorized as either “active” or “passive”?
How to categorize L2
L2 is highly disciplined and invests for the long term. It applies a consistent investment philosophy that combines behavioral finance with rigorous fundamental insight. It defines its “hallmark traits” as “discipline, high levels of active share, low turnover and tax efficiency.”
L2’s team integrates quantitative and fundamental processes to avoid behavioral errors and optimize their investment process, honed over 12 years of working together.
Its offerings include separately managed accounts, ESG mutual funds and two private funds: an Equity Market Neutral Fund and a Long Short Equity Hedge Fund. It is a sub-advisor to the Knights of Columbus for its Long/Short Equity Fund and its All-Cap Index Fund.
L2 doesn’t engage in stock picking or market timing. Its approach to investing is rules-based, replicable and implemented without judgment. Consequently, like the fund families I previously described, it doesn’t fit neatly in the “active” or “passive” category.
Impressive credentials
My decision to work with L2 was influenced by the impressive credentials of its co-founders, Sanjeev Bhojraj, Ph.D and Matt Malgari.
Dr. Bhojraj is a chaired professor in asset management and the co-director of the Parker Center for Investment Research at Cornell University’s Business School. He is the author or co-author of many papers published in peer-reviewed journals.
Matt Malgari received an MBA from Cornell University. He spent 14 years at Fidelity working as an assistant PM, sector analyst, diversified analyst and trader and was the managing director of equity research for Knight Capital Group.
Integration of two disciplines
L2 describes its investment philosophy as integrating quantitative analysis with fundamental analysis. Firms that combine these two investment strategies are often regarded as engaging in “quantamental” analysis.
Quantitative analysis is a structured approach to identify rules and traits by examining large samples of stocks. These rules provide discipline and process that strive to eliminate the behavioral errors that often plague pure fundamental analysts. The drawback to quantitative analysis is the rules have limitations that include an inability to detect often material items that are not available in data like management’s future spending plans, litigation, off-balance sheet items, new competitive entrants, government programs and shocks to the economy like COVID, among other factors.
Because of these different approaches, communication between quantitative and fundamental analysts can be challenging. The focus of the quantitative analyst is on pure finance, physics and mathematics. Their world (math-based) makes it difficult for them to relate to analysts with a completely different orientation (fundamentals).
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This communication issue may be the reason some larger firms, with massive resources, have found it difficult to implement a successful “quantamental” strategy.
Pressure to add value
Advisory firms are under increasing pressure to demonstrate their value and differentiate themselves from the competition. This is difficult to do if competing firms are using the same large fund managers, each of which is touting its ability to screen stocks and achieve higher expected returns.
Increased competition gives advisory firms access to more options, while keeping fee pressure on larger fund managers. Smaller fund managers may have the ability to offer investment options (like separately managed accounts) that are tailored more specifically to the needs of individual clients.
As Bill Gates observed: "Whether it's Google or Apple or free software, we've got some fantastic competitors and it keeps us on our toes."
Categorizing a fund manager as “active,” “passive,” or something else seems irrelevant. There’s a niche for a boutique firm with impressive credentials, low fees and adherence to a well-defined, replicable, academically based process.
Dan trains executives and employees in the lessons based on the research on his latest book, Ask: How to Relate to Anyone. His online course, Ask: Increase Your Sales. Deepen Your Relationships, is currently available.
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.