The last few years has seen competition in the asset management industry increase, fees come under pressure and performance among active managers disappoint. But it was not always this way. And it will not be as we look forward.
The environment has certainly been challenging for active managers, with the advent of quantitative easing across much of the developed world aggressively distorting equity markets.
Earnings growth has been low, while asset price inflation has been high. With interest rates low globally, correlations between assets and also within asset classes have been high. As such, it has been harder for fund buyers to differentiate between good and bad managers.
However, this year has painted a very different picture so far. As a period of normalisation in global monetary conditions begins, active management has returned to the fore.
And there is more to come.
The macro backdrop for equity markets is changing. The end of QE is nigh and interest rates are rising. Rates have begun to climb in the US, albeit slowly, and an increase in the UK is not impossible in the next year.
Stock correlations should continue to fall and dispersions of returns rise. Low correlations between individual stocks and a high dispersion of returns between the best and worst within a sector (known as cross-sectional volatility) create a fertile environment for an active stock-picker with a clear and consistent investment process.
With markets having risen so strongly from their lows in recent years, we should also be aware dispersion can be amplified by market direction. Put simply, dispersion increases the most when market downturns occur, which is when active managers add the most value. We are now eight years into this current equity bull run. There will be a time soon when active managers really prove their worth.
Lastly, some markets are simply less efficiently valued than others, which is structural rather than coincidental. As such, some asset classes provide a substantial opportunity for active security selection.
Not all active managers are the same
There is a raft of research asserting that the average actively managed fund underperforms its benchmark index net of all fees. However, there are some clear reasons why this is the case – and it neither implies a lack of opportunity nor a dearth of skilled investment professionals.
The really important point is that a large number of managers align their portfolios so closely to the benchmark index that they make it difficult to outperform on a net-of-fees basis. For example, a fund with a tracking error of 3 per cent and a total expense ratio of 1.5 per cent can only deliver net relative performance in the range of -4.5 per cent to +1.5 per cent. In other words, the chance of underperforming the benchmark over any randomly selected period is three times that of outperforming.
An influential research paper published in 2013, entitled “Active share and mutual fund performance”, coined the term “closet indexing” to describe the practice of hugging the benchmark index while claiming to be an active manager and levying fees for as much. The author asserted that “active share” can serve as a useful guide in differentiating between closet indexers and those that genuinely seek to add value.
Interestingly, an earlier study, “How active is your active manager?”, found the percentage of actively managed funds across the US asset management industry with an active share above 80 per cent fell from around 67 per cent to 20 per cent between 1986 and 2009, while those with an active share of 0-20 per cent (closet indexers) rose from 2 per cent to 15 per cent.
This dynamic probably reflects a greater fear of materially underperforming the benchmark than an ambition to outperform. However, the irony is that, in pursuing such a safety-first approach, closet indexers have advanced the case for passive management, which would probably not have been viewed as such a compelling alternative otherwise.
In essence, every single index tracker pursues a capitalisation-biased, long momentum strategy. This means they buy high, sell low and passively contribute to the inflation and bursting of asset bubbles. The same can be said of closet indexers.
However, true active managers are ideally placed to exploit the valuation anomalies created by the indiscriminate buying and selling of the capitalisation-weighted market.