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Covering the bases with active investing

Covering the bases with active investing

"It's a beautiful day for a ballgame. Let's play two!"—Ernie “Mr. Cub” Banks

October marks the beginning of the Major League Baseball (MLB) playoffs, which will culminate with the 113th World Series later in the month. There seems to be particular intrigue this year regarding the Chicago Cubs, who have not won the Fall Classic since 1908. Since the team’s last World Series championship, there have been 18 U.S. presidents, four states admitted to the union, U.S. population growth from 88 million to 323 million, and more than a 600-fold increase in U.S. gross domestic product. The Cubs were the first team to secure a berth in the 2016 MLB postseason, clinching the National League’s Central Division title in mid-September. Is this the year that the ballclub from the North Side of Chicago finally breaks its 108-year championship drought?

Practitioners of each profession must be able to accurately interpret the signs—whether emanating from the global financial markets or the third-base coach.

We at Aberdeen don’t think that it’s a stretch (or even a wind-up) to find similarities between the “grand old game” of baseball and asset management. In our view, both require a significant level of teamwork and a focused playbook. Furthermore, practitioners of each profession must be able to accurately interpret the signs—whether emanating from the global financial markets or the third-base coach. The manager of an MLB team with a relatively young and inexperienced roster most likely would prefer to take a “hands-on” approach in an effort to ensure that his players master the fundamentals of the game. In contrast, the manager of a successful MLB team with a significant number of veterans might choose to use the same line-up every day and look for a core group of players to take leadership roles.

In the financial arena, investors have long debated the merits of active versus passive management of assets. Some argue that it’s better to allocate money into actively managed funds, citing the potential for outperformance by highly skilled and knowledgeable active managers. Others maintain that even a track record of success and experience has its faults, believing that passively managed funds are a more practical investment. Which one is the better of the two? This question has provided fodder for lively discussions among financial experts and commentators for a long time, and it remains unanswered.

In our view, there are some commonalities between America’s pastime and active investing. The Society for American Baseball Research (SABR) has developed a system for evaluating each MLB player’s relative performance. Included in the organization’s broad set of statistical analyses, collectively dubbed “sabermetrics,” is wins above replacement (WAR). This statistic indicates a player’s contribution to a team above an average level of production. For example, a player with a WAR of 4.5 is expected to contribute an average of 4.5 victories to his team above “replacement level” in a given season.

The effectiveness of an asset manager is assessed in part though alpha. Alpha measures an investment’s risk-adjusted annualized performance relative to a benchmark index over the preceding 36-month period. We think that alpha is comparable to WAR on the baseball diamond. That is, MLB teams have differing levels of talent. Some are considered to be better than others because they have more talented players on their rosters and, therefore, are generally expected to win more than half of their games in a given season. First-year expansion teams or those with a disproportionate share of inexperienced or less talented players are projected to post more losses than victories. With investment management, the market is at the “.500” level (an even number of wins and losses), and one might deem a manager whose team exceeds expectations as adding alpha.

Additionally, Active Share is used to evaluate active management and focuses on how individual stock weightings in a portfolio differ from those in a benchmark. In 2009, Martijn Cremers and Antti Petajisto, researchers from Yale, published a study in which they examined the proportion of the allocation of stock holdings in a mutual fund that differed from the composition of its benchmark.1 The greater the difference between the asset composition of the fund and its benchmark, the greater the Active Share. On the baseball field, in theory, more at-bats for players with stronger skill levels should deliver a higher team batting average. In this vein, both MLB managers and investment teams strive to outperform their competition. An active asset manager may wish to deviate from the market as much as possible (i.e., generating higher beta2) so that the positive effect of investment positioning is visible. Consequently, high Active Share may help a manager to enhance a portfolio’s performance.

Aberdeen’s global equity teams employ fundamental, bottom-up analysis, which is characterized by intensive, first-hand research and disciplined company evaluation. We believe that a company’s inclusion in a benchmark index is not an indication of its business quality or valuation; therefore, we focus on each investment as an absolute position and invest only in companies we like.

Whether competing in the fields of baseball or investment management, we believe that maximizing risk-adjusted returns is the key to success. In our opinion, active investing enables asset managers to “come off the benchmark” and can add value for their clients over the long term.

1 Source: Martijn Cremers and Antti Petajisto, “How Active Is Your Fund Manager? A New Measure That Predicts Performance,” Yale School of Management, March 31, 2009

2 Beta is a measure of the volatility of a portfolio in comparison to a benchmark index.

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