The pressure on active managers to demonstrate they are worthy of their fees is forcing them to provide ever more granularity on their portfolios.
Active fund managers have been roundly criticised in recent years on various issues, not least their collective inability to outperform passive benchmarks and charging higher fees for this lack of delivery.
However, active managers argue that, while index funds may have the advantage in rising markets, it’s in volatile downturns that active management can prove its worth. If this is so, 2020 has provided them with the perfect backdrop.
“I suspect many active managers are doing better than passives this year; the exceptions being the value guys,” Rossen Djounov, head of Asia at Swiss active fund house GAM, told AsianInvestor.
Some performance data suggests this has indeed been the case. The major market rebound in the second quarter saw 63% of managers tracked by eVestment outperforming their benchmarks.
Berlinda Liu, director of global research at S&P Dow Jones Indices, said that while this was true, it was only a short-term blip in the trend.
She said 64% of mid-cap and 57% of small-cap funds beat their benchmarks in the past two quarters.
“However, this short-term success had little impact on their long-term scores: 82% underperformed over the past 15 years in both categories,” added Liu.
THE MEGA-CAP CONUNDRUM
One of the other big features of the past decade has been the phenomenal performance of a few mega-cap tech stocks. Their outperformance has favoured index trackers over active funds, as active managers have tended to under-represent the real heavyweights in their portfolios.
Active managers are thus caught between a rock and a hard place. Criticised for benchmark hugging if they just replicate the index, they underperform when they veer from this path. Unless, that is, they can identify the next wave of winners.
Morningstar typically analyses fund performance using measures such as Sharpe ratio and tracking error. In recent years, such analysis has also highlighted ‘active share', which indicates the degree to which a portfolio differs from the constituents of its benchmark index.
If markets are favourable, a manager with a high active share and tracking error may also provide considerable alpha. Of course, the reverse is also true for managers that get their bets wrong.
Nonetheless, active share is a measure that identifies those managers who are genuinely active.
Liu said: “In our view, a truly active manager is one with a high active share – that is where 80% or more of the portfolio looks different from its benchmark. Portfolios with less than 60% active share are unlikely to perform as well.
The dominant display of mega-caps and the marked underperformance of value stocks in recent times have altered this dynamic. Djounov said “now everyone wants to analyse correlation to equity/market factors, as value has done so badly and quality large-cap growth has done so well.”
The new requirements from consultants and investors include showing how well a manager is at gaining exposure to ‘disruption;’ fast-growing mid-cap companies, like Tesla was a few months ago.
“Not owning [a handful of big tech companies] has been a major risk for active funds, so many portfolio managers have had to close their underweights in [the] FAANGS (Facebook, Amazon, Apple, Netflix and Google) and the likes, leading to the active share falling,” said Djounov.
“In this environment, having a high active share and outperforming at the same time has become valuable, as it suggests the portfolio manager is actively finding disruptive growth opportunities who are outperforming the mega-cap quality growth names.”
The attitude of asset owners towards active management depends largely on how much their mandate allows them to be truly active.
Georg Inderst, an independent adviser to pension funds, told AsianInvestor that factors include the internal resources available, preferences for regional exposure, time horizons, risk and liability profiles and the efficiency of the investment governance structure.
“There are pros and cons to the endless and often dogmatic active-passive debate,” said Inderst.
“Both [active end passive] approaches have risks that may also vary over time,” he added. “To be clear, active does not mean high-turnover, and passive does not mean buy-and-hold.”
New Zealand Super, for example, takes active management positions outside of its passive reference portfolio to generate additional returns. This can include active equity, arbitrage, strategic tilting, real assets, emerging markets, timber and liquidity management.
The investment ride can be bumpy because, as NZ Super chief executive Matt Whineray points out, volatility is inherent towards portfolios weighted towards growth assets. But with a long-term horizon, the strategy will more than likely pay off.
For an insurance asset manager, the considerations are more nuanced. Mark Konyn, chief investment officer at insurer AIA in Hong Kong, has often complained that active managers are not justifying their existence.
“Active management can be tricky and it costs more to execute than passive buy and hold,” Konyn told AsianInvestor.
He said AIA’s experience is that asset owners with sufficient scale often bring these capabilities inhouse as a result of this.
“We have a mix of active, quant and passive strategies spending both our risk and fee budgets carefully,” Konyn said. “For listed equities globally, third-party managers have struggled to demonstrate consistent outperformance, particularly after fees. For bonds, a balance between total return and/or yield with credit risk is paramount. Hence it is always active management.”