- 2017's new paradigm and uncertainties increase the probability of security price dispersion and offer greater opportunity for active managers to outperform.
- The potential reward for selecting 'truly active' managers is significant and sustained uncorrelated investment returns.
- When evaluating managers there are specific qualities and characteristics that matter.
- The appropriate active/passive mix for any investor depends on their beliefs about how markets unction, how securities are priced and the value of diversification, as well as their investment goals, governance budgets and how they frame risk.
Introduction: a time for active managers
We begin 2017 facing a new paradigm and an ever more unpredictable world. Markets are dislocating as the impact of a changed political and economic direction in major regions begins to be felt, and the benign monetary policy of the past eight years is wound back. In this environment, the potential for active managers to outperform is heightened and the reward for identifying those managers most likely to do so should be greatly enhanced.
In June 2015 we published the paper, 'Not all active managers are created equal – what to look for and why' illustrating the merits of the best active managers. Now, the changing external environment more than ever brings this into sharp focus, with talented active managers well placed to take advantage of the increases in volatility and lower stock correlations likely to ensue. Indeed, this is exactly the environment that plays to the strengths of skilled stock pickers.
In our updated paper (of which this is a summary), our mission remains to help investors better understand the investment choices available to them.1 By applying the requisite due diligence, investors increase their chances of finding exceptional active managers who can achieve desired investment outcomes. This is especially true against the backdrop of social, economic and political dislocation we face as 2017 unfolds.
Rewards for identifying excellence
Our updated paper challenges the notion that active fund management – in aggregate and after fees – is a negative sum game. This broad assertion ignores the distinction between closet trackers and truly active managers. By definition closet trackers typically underperform after fees. By contrast, the potential reward for selecting a genuinely talented fund manager can be a significant and sustained uncorrelated source of investment return.
Indeed, the following finding highlighted in the CFA's Financial Analysts Journal confirms this: "…investors who can identify superior active managers should always expect …a substantial impact on returns with only a modest impact on total portfolio risk. Finding such managers is not easy or simple – it requires going well beyond assessing past returns – but academic studies indicate that it can be done."2
How to differentiate between active managers
Given that skill can take some time to prove statistically, the task of identifying those active managers likely to outperform over the longterm is not a simple one. However, as our paper demonstrates and empirical underpinnings suggest, there are many factors that can lead to sustained active investment outperformance. These include adherence to a proven investment philosophy and process, stock picking that exhibits high conviction, contrarian thinking and concentration, being capacity aware, employing a patient investment approach, capturing environmental, social and governance (ESG) factors and embracing diversity within fund manager teams.
These and several other key qualitative factors are critical to selecting a skilful active manager. Moreover, given the very real prospect of more modest and more volatile long-run investment returns going forward, applying the requisite due diligence is time well spent.
Qualities that matter:
Although no one factor or quality confers an edge, a manager should have a proven and repeatable investment philosophy and process that captures their defining investment insights and value adding techniques. What's more, the investment approach must be backed by a culture that is dynamic and interactive and by processes that are team-based, performance driven and risk aware.
Applying the 'three Cs' – high Conviction portfolio positions, Contrarian/independent thinking and high portfolio Concentration – is also important. Similarly, a good active manager will have an 'investing to win' mindset, typically evidenced by a high active share and a moderate tracking error, underpinned by intelligent stock picking rather than highly correlated and concentrated industry positions.
Another important factor is dedication either to a single investment style in which success has been demonstrated, given that each investment style demands a different mind and skill set, or to a stock picking approach which has successfully emphasised particular style traits consistent with the investment outcomes targeted.
There is evidence that employing a patient investment approach can lead to outperformance. Patient investors benefit from the greater predictability of asset prices over the longer term, which allows skill to surface. Talented managers also have a strong sell discipline and take a considered approach to portfolio turnover, given the potentially adverse effects of high transaction costs on fund performance.
Finally, as ESG factors become increasingly material to company valuations, to efficient capital allocation and in minimising reputational, operational and regulatory risks, it has become increasingly important to integrate them into the investment process.
Common characteristics:
When it comes to common characteristics, talented managers tend to have an ability to:
- combine proprietary macro and micro insights into investment decision making;
- articulate how ideas find their way into their portfolio;
- be open to debate and genuine challenge;
- recognise and control their behavioural biases, particularly groupthink, misplaced confidence and an aversion to realising loss making portfolio positions;
- recognise the capacity constraints of their chosen strategy;
- add value in both rising and falling markets, particularly the latter, and
- put risk management at the front and centre of all that they do.
Does gender make a difference?
Then there's the question of gender. Although the evidence is sketchy, female fund managers appear to be better risk managers than men, generating more consistent and less volatile performance than their male counterparts, with mixed sex teams seemingly outperforming single sex-run funds.
Conclusion
Ultimately, the appropriate active/passive mix for any investor depends on their investment beliefs about how markets function, how securities are priced and the value of diversification, as well as their investment goals, governance budgets and how they frame risk.
We would emphasise, however, that taking the line of least resistance and opting for a low-cost passive solution every time is rarely the best way forward.
Suffice to say, despite the practical problems often associated with determining active manager skill, by applying the requisite due diligence investors really can increase their chances of finding potentially exceptional active fund managers who more than earn their fees over time and deliver desired investment outcomes.
Moreover, given the prospect of more modest and volatile long-run returns going forward, and prospectively greater dispersion in stock returns, seeking out skilful active managers really can be worth the governance budget.