Much of the debate about active management suggests that it is tough to master and has faced a variety of different headwinds. However, in our view, there are areas where significant value can be created – it’s just a matter of where and how we access it.
First, our view of what active and passive management means. At a high level, ‘active management’ involves individual portfolio managers or teams identifying and making investment decisions based on research, professional experience and judgement. Passive management relies on rules specified by a market index. By definition, passive management signifies belief in market efficiency, whilst active management implies some level of exploitable inefficiency.
Here, we share some of our views on active management, ahead of a broader piece of research which details the headwinds and opportunities for active managers in more depth.
1. It’s not always a zero-sum game
Our first observation is that although the maths of a closed market is that active managers on average own the market, so therefore on average they must return the market less fees charged is true, market participants operate with different investment objectives and time horizons. Market indices are constantly changing, and this requires a certain level of trading to keep up. Index funds have to sell to someone when stocks leave the index and buy from someone when they come in. The greater the penetration of indexing in a market, the greater the potential wealth transfer. Pederson (2018) provides estimates of the value transfer and at 50% penetration there is around 60bps of potential value to be theoretically gained by switching.
In conjunction with other arbitrage and low-risk enhancement strategies, enhanced index performance offers one path to additional value in otherwise efficient markets.
2. Being different is important
Warren Buffett famously supports using index funds, but always with the caveat that it is better to average in to a diversified and cheap index fund than to pay lots of fees or to not understand what you are doing. We think there are parallels with investing in stocks and being in business – where there should be a concentration on what a person understands, what meets their criteria, and what they could commit to for an extended period of time. Diversifying into areas you don’t understand is akin to going into business blind, and fraught with risk.
Studies into higher-conviction mandates also supports the idea that if you have skill, it is better to focus on the best opportunities on their merits1. Some studies show that managers of portfolios that are concentrated have done better than managers who are closet indexers, i.e. those who own lots of other securities simply to reduce risk relative to a benchmark3.
One measure of this is ‘active share’2, which simply measures the degree to which a portfolio looks like the index (0 = the index and 100 = none of the index). In this study of 2650 US mutual funds, managers with high active share (over 80%) exceeded the benchmark by an average of 1.5% after fees. This idea is fairly intuitive in that you are paying primarily for the investment decisions that matter, those different from the benchmark.
They also tie into other research that supports the idea that managers ‘best ideas’ do actually add value. A study entitled ‘Best Ideas’ in 2010 found that it was the highest conviction, largest active positions in portfolios that added the most value (between 1-2.5%), whilst those used as risk management added or subtracted value.
A consistent feature of higher conviction funds has been longer holding periods and by definition lower turnover6.This would appear to be linked to both a focus on longer term fundamentals that can’t be arbitraged away easily.
3. Focus on the less crowded
Active management is often portrayed as the ‘law of active management’ where quality of returns is a function of relative skill times opportunity. Both of those notions should work better in markets with a wide variety of skill levels, and a wide variety of securities.
There are several ways we can look for those attributes.
We can look for markets where there is wide dispersion in manager and investor outcomes, implying a wide range of relative skills. David Swensen of Yale University Endowment fame espoused this idea, where the existence of very wide ranges in performance across a universe of investors implied wide differences in relative skill and therefore a market where being active stood more chance of success.
This was supported elsewhere where markets with greater heterogeneity and cross-sectional return dispersion such as small companies and emerging markets had greater opportunity and managers out outperformed relative to large cap counterparts1. These market segments are also known to have limited broker research coverage.
In our view, managers in these markets can gain an information advantage through company due diligence and also exhibit greater persistence in outperformance than larger efficient markets.
4. Flow of funds as a tailwind
In equity markets it is the marginal buyer (and seller) that determines the last price. As the volume from the buyer is matched with the seller, the last price is set at a level that reflects the underlying demand and supply dynamics for a particular security. Where there is excess demand, a higher price is required to clear the volume from the seller. Periods where there are persistent imbalances in demand and supply typically result in large price movements.
What this means for active managers is the flow of funds can serve as a tailwind, particularly in the case where the fund flow is structural and into similar active strategies. In our view, managers operating in these markets can be shown to deliver above average outperformance.
Where to from here?
We look forward to bringing you our research paper, where we will more comprehensively explore how we believe active management should be approached in investment markets in the 2020s, to best serve the investment portfolios we manage on behalf of clients. Some of the areas we look forward to telling you about include:
- Why we believe active management in its traditional form is sub optimal and what we think needs to change.
- What we think is important in an active management program and where we think that is going forward.
- Why we believe active management is more important than ever.
1 See: references, 2
2 See: references, 2
3 See: references, 3
1 Gupta, A., Oberoi, R., Subramanian, R., 2019. Evaluating Opportunities in Active Management”, The Journal of Investing 29 2019
2 Cremers, M., Active Share and the Three Pillars of Active Management: Skill, Conviction, and Opportunity. 2017. Financial Analysts Journal 73.2
3 Cohen, R., Polk, C., Silli, B., 2010. Best Ideas
4 Mauboussin, M., Callahan, D., and Majd, D., 2017. Looking for Easy Games – How passive investing shapes active management. Credit Suisse
5 Cremers, M., Ferreira, M., Matos, P., Starks, L., 2015. Indexing and Active Fund Management: International Evidence
6 Lan, C., Moneta, F., Wermers, R., 2018, Holding Horizon: A New Measure of Active Management
7 Cremers, K., Fulkerson, J., Riley, T., 2019. Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds
8 Pedersen, L., 2016. Sharpening the Arithmetic of Active Management, Working Paper, November 2016
9 Sharpe, W., 1991 "The Arithmetic of Active Management." January/February 1991 Financial Analysts Journal (Vol. 47)
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