For some investors, a passive portfolio, reflecting the relevant indices, is simpler and more cost-effective than trying to identify the best active managers. However, many investors wish to knock the index and seek out skilled active managers to do so. A strong implementation approach for active management is three-sided: first, identify those asset classes where active management has the most excellent opportunity to deliver outperformance; second, identify the best active investment managers; and third, negotiate a competitive fee structure that is expected to deliver above-index returns on an after-fees basis.
It is rightly true that there is no single correct answer to the question of which manager is right for which investor. Instead, guiding principles to undertake a qualitative overview of which asset classes offer the best active management opportunities, followed by a comprehensive assessment of investment manager strategies globally is what we hold for you to deliver you all. Where investors have a belief and conviction that active management can add value over the long term, they need to target those asset classes and opportunities that are most compelling. Some questions to consider are: Can you achieve the desired result at reasonable fees? Do you have an agreeably long investment time horizon to tolerate the declines and waves in a performance that come with an active management approach?”
Finding the right active manager
While there are multiple methods to manage money successfully, the best managers typically have characteristics and approaches to the ways in which they operate that set them apart from the crowd. As with any profession, some investment managers are more skillful than others, and can consistently reveal and utilize opportunities created by the market’s mispricing of assets. The key factor is the quality of the people who make the investment decisions, using a skilled, robust, and repeatable approach. “League tables have no understanding of whether the investment manager was just lucky or exhibited skill. What we look for is a well-articulated investment process that, together with a skillful investment team, is expected to deliver outperformance on a systematic and consistent basis.”
For example, a top-notch emerging market equities manager will typically have dedicated analysts based in the relevant countries with their ears to the ground. Similarly, the best corporate bond market managers will produce top-quality research to identify issuers that may be at risk of downgrade or default. Other attributes that include for are superior insights and understanding of behavioral factors, a willingness to take a longer-term view, and an ability to “join the dots”.
Choosing the right asset classes and markets
Highly skilled active managers can immediately grab on alpha opportunities created from inefficient pricing of assets. Typically, inefficient markets are less developed, with slower information dissemination and less institutional investors and analysts. The more inefficient a market is, the better the potential for outperformance with active management. An important part of an active management strategy is to recognize which markets offer sufficient raw market potential for alpha generation.
A key consideration is market breadth with a vast pool of diverse investment opportunities and sufficient liquidity. The quality and flow of price-sensitive information and the number of sophisticated investors participating in a market is also important in assessing opportunities for active managers to gather better information than others.
From a qualitative perspective, the best equities opportunities for active management outperformance are in small caps and global emerging markets. In fixed income, analysis shows that the highest raw potential is in emerging market debt and high yield markets. Given their relative efficiency, the lowest raw market potential for active management outperformance is in US large-cap equities and government bond markets.
Evidence of outperformance
This may all be good and well in theory, but what about the actual delivery of outperformance? Analysis of historical returns across various asset classes shows some surprising results, especially net of fees. Analysis has shown that the Australian equity active manager has outperformed on both a gross and net of fees basis. Over both five and ten-year measurement periods, the manager generated in excess of 1%pa outperformance against the relevant index, net of fees. In Australian small-cap equities, the manager outperformance was very strong: 10%pa outperformance over five years and 7.3%pa outperformance over ten years. In contrast, the emerging market equities manager outperformed the index over ten years, gross of fees; but the high fees typically associated with this sector eroded most of the alpha gained.
In Australian fixed income, the manager’s net of fee performance was largely flat over the various time periods evaluated. Over time, these results are expected to shift as we go through different phases of the market cycle. For example, the alpha delivers by active managers has generally been more sedated since the Global Financial Crisis, largely explained by the bull market supporting growth across asset classes and sectors. However, skillful asset managers are expected to show their worth as markets ‘normalize’ and the inevitable market corrections occur. Our analysis shows that the historical results can be very time-sensitive and depend on when the analysis is carried out. Besides, while some asset classes look attractive on a qualitative basis, the historical results on an after fee basis are not that convincing. On balance, the preference may still be for active management, but investors must have great confidence in identifying and hiring superior active managers and they must be able to negotiate competitive fees.
Any advice provided by Laverne is general in nature only and does not take into account the personal financial situation, objectives or needs of any particular person.