‘You don’t (always) get what you pay for and ironically you may also get what you don’t pay for !’

The debate between the advantages and disadvantages of active and passive management is always intense...however in this write-up let us keep passive management aside and be focussed on active management itself.

Active management resembles ‘you don’t (always) get what you pay for and ironically you may also get what you don’t pay for.’

Let me explain,

·         Normally we pay a differential rate (price) for obtaining diverse qualities of goods and services in the real economy, in day to day life...some examples are...

·         If I pay a higher fare I can fly business class with more facilities relative to economy class.

·         If I pay more I can drive a sedan car instead of a hatchback or an entry level vehicle. Even among the same segment there will be a price difference for vehicles with more features, engine power, frills and gadgets.

·         If I am willing to pay a higher rate-I can see a movie in a prime-time show instead of a matinee show on Monday morning.

·         I can travel Rajdhani Express 1^st class-if I am willing to shell out more money-than any other train.

·         I can buy a high-end laptop or mobile phone-with more features for a higher price than other lower-end phones and laptops with lesser applications.

·         I can go for a swanky apartment at an enviable address by paying a couple of crore relative to other locations.

·         I can take a holiday to Europe by paying more relative to a cheaper holiday in South East Asia.

·         I can buy a Rolex or an Omega by shelling out more money than watches that are cheaper

·         I can stay put in a 5-star deluxe hotel by paying a much higher tariff than the ones in the lower segments

·         I can avail of top-class healthcare facility by paying more to state-of-art super-speciality hospitals as compared to government run facilities.

·         I can buy branded shirts, shoes and everything else by paying more relative to lesser known brands.

·         I can buy higher quality soaps and toiletries for a higher price relative to ones with lesser features

Inference: In almost every aspect of life there is a price differential for a higher quality, more features, more punch (perceived or genuine) and...this implies that you usually or typically get what you pay for!

 Does this happen in active management?

·         Let us hypothesize that all portfolio managers in a given sample beat the market (a rare feat)-and let us also assume that they all charged a uniform rate of 2% (expense ratio) as their fees. Further assume that all other costs like exit loads etc (if any) are common to all schemes in the sample.

·         Although all managers in the sample outperformed the market (index)-there is yet a very wide range of outcomes (at random) i.e. a wide variation in returns.

·         It implies that unlike the examples we saw above-some investors don’t get what they pay for while other get what they don’t pay for.

·         The cost is uniform in our sample-however some managers beat the (market) index by a wide margin-whereas some by a much lesser margin...

·         ...This is almost like saying that all car-buyers (in a given sample) paid a uniform price-but some at random got a Mercedes while others at random ended up with Nanos’-in this example let the index be a ‘two-wheeler’-hence everyone ‘out performed’ by getting cars-but the outcome was a very wide range for the same price.

·         One more analogy-all airline passengers paid exactly same fare-but a few (at random) serendipitously ended up in business-class and at the same time others were squeezed into economy.

·         Investors pay managers to get the best returns-(although best in active management also entails higher risk)-none the less the mandate is ‘usually’ to earn high returns (i.e. in the given sample)-but in reality this does not happen even if all managers hypothetically beat the market...

·         ...For the same price (expense ratio, loads & other costs, if any)-some investors at random will end up in 5-star hotels while others will end up in much lower segments.

·         Hence, in active management-YOU DON’T (ALWAYS) GET WHAT YOU PAY FOR AND YOU MAY ALSO GET WHAT YOU DON’T PAY FOR. This is the randomness of outcomes-the hall mark of an efficient market.

·         The above is true for all forms of active management i.e. stock picking, manager picking, timing, advisory-the rates are more or less similar-but the outcomes exhibit a very wide range and variation.

·         In the zero-sum game of outperformance, even though costs and expenses are similar-one may end up with a good or a bad out come-at random. Both outcomes are transient and it is almost impossible to differentiate luck from skill.

·         On the other hand in passive indexing-one is normally getting what one pays for-the average market return in a properly-run index fund / ETF.