David Barse, Founder & CEO, of XOUT Capital, discusses his views on the Active vs. Passive Debate
I spent the first 25 years of my career pursuing and promoting an active management strategy driven by an aggressive/conservative investor. From 1991 until 2008, active management was fun. Whether it was picking stocks or debt instruments, finding holes in the marketplace where we could drive a truck through was great fun—even later, when exploiting these inefficiencies became threading a needle, the joy was still there. Doing extensive research and unearthing "value" that others did not see was unbridled ecstasy.
Then came seven years of torture. Cash was king, except when investors wanted it back, which was everyday. Suddenly, decisions about what securities to sell to meet redemptions were paramount. Everyone in the investment business learned the language of “behavioral finance” and our choices were scrutinized through the lens of “personal bias.”
Managers adopted the strategy “keep your highest conviction names and sell everything else”—except what does that even mean? It signified different things to different people. It could be the cheapest name, but "cheapness" had its own definition. Everybody had their own justification for the cheapness which could also mean their favorite investment.
It could have been the largest weighting; but selling your highest weighted security (if you could sell it at all) was an admission of failure. How can you sell your largest position if it means taking a loss? Certainly, the marketplace is missing the real "value" and all we must do is wait to be rewarded. No matter the benchmark or risk adjustment applied, underperformance was a near certainty.
In the past, quality information was fleeting and rare. But technology had disrupted the way information on the "street" was disseminated. Now, technology has made data ubiquitous. The initial response was to invest in better data, faster data, even venturing into alternative data—the more obscure, the better. Customer satisfaction surveys from the 1970s, sure, or parking lot utilization rates, you bet. Rule FD came along to level the playing field further and end things like "whisper numbers". It made no difference—active management was challenged. Only the best and brightest thrived, and even those historically well-respected managers are retiring to run their self-directed family offices or invest in sports franchises.
A newly organized investment strategy by XOUT Capital®, which I founded, is exploiting all of what I learned in my investment career and is scalable to adapt to future innovations and disruptions in asset management and across sectors. Passive investment strategies will continue to dominate the flows of investment capital for the foreseeable future. The claim by active managers that this could not happen, or for heaven's sake, should not happen, is history. Passive vehicles performed almost perfectly during one of the most volatile short-term market disruptions in history, March 2020.
However, the flaws of passive investing are apparent. When you buy a broad market index, you get everything in that index irrespective of how good or bad the underlying constituents are. What XOUT™ does is simple: we focus on excluding the companies in a broad index that you do not want to own. We call this "smarter beta." Smart beta investing seeks to combine the benefits of passive, rule-based investing with active management, where the active component is limited to creating the rules themselves.
XOUT™ is smarter because it is easier to figure out which companies to exclude rather than picking the winners. Not all companies are equipped to survive in an increasingly disruptive and now virtual economy, so don’t own them. The challenge with smart beta strategies is that they are just another riff on seeking to pick the winners, whether identifying a winning sector or best picks within a specific theme. In the case of a broader market approach, XOUT™'s smarter beta goal is to generate alpha (excess return above the benchmark) by removing unwanted names from the benchmark.
Other than short-sellers, active managers are driven by identifying winners: top picks, highest conviction weightings, best values. These managers consistently fail to outperforms broad market benchmarks because choosing winners is tough in any moment and nearly impossible to do consistently. The indisputable reality is that few stocks can create shareholder wealth over the long-term; losing stocks are the overwhelming preponderance, a dime a dozen (yes, that is a knock-on value stocks).
Avoiding the companies that do not measure up is easier to do and performs better. In an investment culture where differentiation is defined by what a manager owns, little capital is focused on generating sustainable outperformance by eliminating perennial laggards. XOUT Capital® seeks to prove the benefits of this new way of thinking.
Even before the global pandemic, active unceasingly struggled. Acceptance of the reality that passive is a better way to invest does not mean that you must be dogmatic. XOUT™ offers the best current solution: The only thing more important than what you put in your portfolio is what you XOUT™.
