The growing popularity of equity index funds and equity index exchange traded funds (ETFs), combined with several academic studies of the costs and benefits of active management versus indexing, have raised questions in the minds of many advisors and investors about the benefits of active equity management. We believe these studies have given “active managers” a bad rap by grouping all active managers into a broad, single universe and not differentiating between those managers who are truly active, and add value, and those managers that call themselves active but offer little opportunity for outperformance, net of fees, based on their true investment style.
The growth of equity index funds and index ETFs is premised on achieving market-like performance at as low of a cost as possible and letting the asset allocation decision drive the quest for alpha. Passive equity investors know that their results can be expected to be close to the index that their fund or manager mirrors, less expenses. Active management, they say, is uneven at best, and it is difficult to find a manager who has the skill to consistently outperform, net of fees. But what if there was a way to separate the “wheat from the chaff” and identify those active managers whose approach consistently provides the opportunity for outperformance?
To beat the market, you have to be different than the market. This statement makes intuitive sense. An “active manager” whose process consistently invests in a diversified portfolio of index constituents, and weights them in a manner that provides little difference from the benchmark, significantly reduces the potential to outperform the market and is essentially a “closet indexer.” On the other hand, a skilled stock picker who is not afraid to be “different than the market” by buying companies based solely on their investment merits (rather than their inclusion in or weighting in an index) offers more potential, over longer periods, to beat the market net of fees. Identifying these managers, however, can be difficult.
We believe that advisors and investors stand the best chance of achieving market-beating performance by using the following tools in selecting active managers:
Focus on managers with a high “active share”
Managers who demonstrate high active share approaches to investing have a greater potential to outperform over longer
time periods. They have the opportunity to beat the market over time because they are consistently different than the
market.
Incorporate downside capture ratio in your criteria
A full market cycle experiences periodic corrections. The mathematics of return suggest that managers who minimize the
damage during market downturns are in the best position to provide superior returns over a full market cycle.
The skills of any active manager are best evaluated over a longer time horizon
Viewing manager performance over at least a full market cycle is critical in determining the benefits of a manager’s active
style and ability to weather difficult markets.