Smart Beta Series: Episode 2 - Active Management
Last month we started our “Smart Beta Series” with a description on passive investments. (For those who have not gone through that yet, please refer to the July 2018 Newsletter)
This month we continue in our series explaining the role of active management in the investment universe. Active management of investments is the kind of investment management that plays the largest role in investment markets currently and makes up the lion’s share of global assets under management. Today we dive a little deeper into what active management is and the pro’s and con’s thereof.
What is active management?
Active management is effectively any strategy that aims to outperform the market, as measured by the market indices. The outperformance is generated by applying strategies that differ from market weighting methodologies (remember market capitalization weighting is the basis for most passive investing).
Active management as a blanket term has evolved over the years but often involves human judgement, experience and skill to outperform the market and generate the “holy grail” of active investment strategies; ALPHA.
What is Alpha?
Alpha is the return generated over and above (or below) that of the market index which would be considered the benchmark. Alpha aims to be positive but can of course be negative as well.
For example, consider a US Equity Fund Manager, Fund ABC. Fund ABC’s objective is to outperform the S&P 500 index. The fund manager selects a handful of stocks that he thinks will outperform the market for some reason (this could be because they are underpriced, are growing faster, more sustainably, or for a multitude of other reasons). These stocks, say 30 of them in total, will generate a return for Fund ABC but that return will differ from that of the market in this case the S&P 500 index (which is a passive market index made up of the top 500 stocks in the US). In this example, the fund generates a return of 12% over the period whereas the index only returns 10%. Remembering that the 10% that the index returned is referred to as Beta. In this case the relative out-performance of 2% (12%-10%) by Fund ABC is referred to as Alpha. Of course, if Fund ABC had returned 8% then it would have had a 2% Negative Alpha.
Why is active management so popular?
Historically speaking investing was not as easy as holding an ETF of the market via a stockbroking account that you could manage off your iPhone. In fact, investing was laborious and expensive for most potential investors, which gave rise to the active investment manager who would apply his specialist investing skill to the investment markets. Active managers worked hard to gather information on potential investments and to identify investment opportunities for investment. This required a huge amount of skill, research and information processing.
Active investing options where in fact often the only way to access the market if you didn’t want to invest yourself, and even then, it was often difficult to access markets. So as more and more money and investors entered into the investing universe the size of the active management pie got larger and larger, which naturally lead to more active investment managers entering the market.
Human psychology also has a role to play in the rise and sustained market share of active management strategies. We are hard-wired to believe that intelligent and educated investment managers who apply efforts to researching small nuances should have an edge in relation to other investors and therefore should be able to outperform the index on a consistent basis. It seems awfully logical and therefore the pursuit of finding the best managers has long been the sole purpose of financial advisors and investors looking for an entry point into the market.
Ability to outperform the market and earn excess returns
Selecting of assets that suit current market conditions
Take advantage of unique information and market inefficiency
Take advantage of human/investor psychology
Flexibility to adjust the portfolio frequently and in short periods
Active strategies are renowned for being high in cost
Inability to consistently generate alpha
Difficulty in selecting best active managers
Reliance on humans who are subject to investor biases
Despite the logical or intuitive view that active managers should outperform over time history has actually shown the opposite. In fact, over 3,5 and 7 year windows around 80% or more of active managers tend to UNDER-perform their benchmarks or market indices that they are attempting to beat.
This can be often be attributed to the high costs, high fees and taxes applied to active management portfolios but also as a result of the fact that human fund managers who apply discretion are also subject to investor behavioral biases.
Active managers are losing market share as many of the more “vanilla” active strategies have been turned into passive or quantitative strategies but still make up the clear majority of assets under management. This is a trend that is likely to continue but in an increasingly more efficient world with data available easily and without massive cost, managers are having to become increasingly sophisticated in attempting to generate alpha, be it positive or negative.