Active managers must be better...

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Intuitively we’d expect active managers to perform better than the market.  Active managers should be smarter, more responsive and adaptable.  They should pick winners, avoid losers and react to downturns.  Do actual investment outcomes support this?

Monday, December 14th 2015, 6:05AM 5 Comments

by Pathfinder Asset Management

The majority of the world is still active

Active strategies attract more investor money than passive – there’s no surprise there.  According to an April 2015 Morningstar report into US domestic, sector and international equity funds, 62% of AUM is actively managed and 38% passively managed. 
The surprise, however, is how fast the gap is narrowing between investors choosing passive over active.  In the year to 31 March 2015 Morningstar recorded massive inflows into passive US funds and huge outflows from active:

If US flows into passive and out of active continue at the current rate, then passive will become larger than active within about 5 years.  (Just to be clear, we’re not suggesting flows of this magnitude will continue – it merely illustrates the scale of the current move from active to passive).

Regardless of how investors feel about passive or active management, it is not in anyone’s interest for passive to dominate – it would be a weird (and inefficient) market if everyone was index tracking.  Presumably the inefficiency of such a market would also open up opportunities for active managers to succeed. 

Is active failing?
Merrill Lynch’s chief equity strategist Savita Subramanian recently said active large-cap managers are on course in 2015 to post their best collective performance against the Russell 1000 index since 2009. That sounds like great news – the best active manager performance in 6 years.  Yet he goes on to note that this means that only 41% of managers are on track to beat the index.  41% beating index doesn’t sound like a compelling case for active (source:  First NZ Capital). 

The underperformance of active managers in global equities is highlighted each year in the S&P Dow Jones Indices SPIVA scorecard.  It is a comprehensive look at active managers across a range of categories such as geographies and market cap of stocks.  The findings must cause nightmares for active managers and their marketing departments – it is grim reading.  Below are the results of US large cap funds vs their S&P500 benchmark (this is not cherry picking a result, this underperformance is consistent across all equity categories in the survey):

The majority of US managers underperform, yet top quartile managers beat their index.  Does this mean we just need to focus on choosing the best managers that sit in the top quartile?  The problem here is the lack of persistency of high achieving managers.  Very few US managers consistently stay at the top for extended periods.  Out of the 682 US equity funds that were in the top quartile as of March 2013, less than 6% managed to stay top quartile at the end of March 2015.

Why is active failing?
The debate is not simply active vs passive – we have to dig deeper.  We have to ask why may active be failing?  The answers may surprise.
A CFA Institute poll from October 2015 asked that question to almost 750 market professionals.  About 39% said that active will always underperform passive, giving reasons like:

1. because of the impact of active’s higher fees and
2. a team of managers cannot beat the collective intelligence of the market

The answers of another 41% of respondents were interesting – they believe that active is failing because of the way managers constrain themselves.  This category is saying managers can outperform, but their own behavior is preventing them – for reasons such as:

1. self-imposed restrictions (like limiting tracking error to benchmark and trying to stay in style boxes of the research houses)
2. active managers have adopted a short term focus (monthly industry performance league tables focus attention on the short rather than long term)
3. managers are lacking opinion diversity and staying in the safety of the herd, and
4. lack of due diligence by managers 

This study is a survey of opinions rather than an empirical study of manager behavior and investment outcomes.  But it does provide interesting insights into why many active managers may be failing investors.  (Note that the percentages above add up to 80% - the remaining 20% of respondents gave a range of other reasons for the failure of active management).

Are some active managers just passive in camouflage?
Respondents to the CFA Institute poll imply many managers may be passive but cunningly disguised as active.  They tell a story of active management and yet deliver benchmark (or sub-benchmark) returns.  This may also be true of product offered in NZ.  Here is what one manager says in their offer document:

“markets are inefficient, and prices don’t always reflect the true value of assets”

So they believe markets are inefficient, which should make the world an active manager’s playground.  They go on to elaborate:

“experienced investment teams, supported by ….resources and systems ….. of ……. size and scale….. are better positioned to identify mispriced opportunities”

So here they argue that large active managers with scale and resource will of course do better than smaller (although more agile) boutique managers.  But unfortunately their return history does not seem to sit well with their claims.  Looking at a range of their funds – including global equities, global property, emerging markets and Australian equities – it is very difficult to distinguish their fund returns from the benchmark – in both up and down markets.  They do not appear to be using their size and scale to identify mispriced opportunities.  Instead their results seem to show they are essentially an index tracker. 

Are some markets different?
Intuitively it makes sense that some markets or market segments are likely to be less efficient than others.  Some markets may be less liquid or have information disseminated in less efficient ways. Some participants may have more skill, better technology or access to more in-depth research.  New Zealand is often seen as such a market.  Our market cap accounts for only 0.07% of global equity markets and we are a concentrated market (for example the top 5 brokers account for 89% of trades, the top 6 KiwiSaver providers account for 86% of AUM).
NZ also has a rather inefficient (concentrated) equity benchmark.  The top 5 stocks are around 35% of the benchmark (as opposed to the top 5 S&P500 stocks being 11%). Getting the call right on the large stocks means a manager should outperform the NZ index. So for several reasons NZ may be less efficient than deep liquid markets like the US and Europe.  There is a case for active management working here.

Having said that, it is not clear cut.  Looking at the Fundsource September report we can compare the passive MIDZ SmartShares ETF to active funds that invest only in NZ shares.  Over 5 years, 8 out of 9 funds beat the MIDZ ETF, but over 1, 2 and 3 years the active funds have a very low success rate: 

Notes:

¹  Funds with less than $2m FUM or that are passive (i.e. other SmartShares ETFs) have been excluded
²  One of these 2 funds achieved the same return as MIDZ but to improve things for active managers it’s counted here as having beaten MIDZ

Is it active, passive or something else?
The active / passive debate is generally quite binary - do you support active or passive?  It is no longer this simple.  Active and passive are now on a continuum – there are plenty of strategies in between. 

How do you classify a global fund that invests in ETFs (i.e. passive building blocks) but takes very active and concentrated views on sectors (healthcare, tech, utilities, financials etc) geographies and factors (large cap, small cap, growth, value etc) based on manager conviction – is this active or passive?  What if the manager overlays cash and option protection strategies for market drawdowns – is that active?  Or is it somewhere between active and traditional passive?  The lines are becoming more blurred.

What about a fund that uses a rules based process to pick 100 of the S&P500 stocks that have the best valuation, momentum, dividend or growth metrics?  What if the manager overlays active currency hedging and downside protection strategies?  It’s not a traditional active fund nor is it a purely passive fund – it is something in between.

There are no easy answers, other than the binary “active vs passive” doesn’t adequately explain many funds and strategies.   Traditional passive (static weight and 100% long only) and benchmark hugging active are not the only options for investors.  Passive can be “smart beta”.  Active can be “unconstrained active.”  Available options for investment dollars are changing - we live in interesting times!

John Berry, Director
Pathfinder Asset Management Limited

Disclosure of interest:  Pathfinder employs “smart beta” strategies (which are referred to in this article).
Seek advice:  Pathfinder is a fund manager and does not give financial advice.  Seek professional investment and tax advice before making investment decisions.

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz

Tags: Active v Passive Pathfinder Asset Management

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