The scarce commodity of active management skill

Whenever shifts in macroeconomic conditions happen, and volatility takes hold of financial markets, investors are told that active management will protect their equity portfolios. 

This is also true of the most recent shift, from the era of lower rates, inflation and volatility of the 2010s to the current one, when markets are beset by geopolitical tensions and uncertainty over the direction of the global economy. 

“This is the time for active management,” or statements to that effect, are often heard in speeches by investment strategists.

But the trend towards passive and benchmark-based investing has been barely affected by the recent shift in market regimes. According to Morningstar, passive funds overtook active funds in assets under management for the first time in 2023, at least with regard to US mutual funds.  

This turning point arose as concentration within global equity markets reached an unprecedented level, driven by the so-called Magnificent Seven tech stocks, whose earnings expectations have been fuelled by the rise of artificial intelligence (AI). 

As a consequence, risk within global benchmarks has also reached record highs. But investors have good reason to be cautious of active equity management.  

Last year, stock pickers performed slightly better than over the course of 2023, according to Morningstar. The weighted success rate of active managers, as calculated by the company in its European Active/Passive Barometer, was 29.1% at the end of 2024, up from 28.7% the previous year (see figure). 

But over the past decade, the average success rate for active equity managers in the 38 categories of equity funds that Morningstar analysed was a “disappointingly low” 14.2%.

So, should investors believe strategists when they say this is a good time to be active – and what exactly has changed? 

If anything, active management has become a more challenging proposition. 

As Thomas Stork, associate partner, equity manager selection, at Aon, points out: “Everything has become more competitive. If you are doing what you were doing 20 years ago, you are not going to be able to compete.”

The poor average performance, on a relative basis, is not due to a decline in skills. In fact, it is the opposite.

Stork says this is the “paradox of skill”. The idea is that as stock pickers become more skilled, the gap between the best and the worst narrows. In other words, alpha becomes scarcer.  

It is a concept popularised by Michael Mauboussin, head of consilient research at Counterpoint Global, part of Morgan Stanley Investment Management, and an adjunct professor of finance at Columbia University. 

By definition, the average active manager will continue to underperform. But the goal for institutional investors should be to avoid ‘average’ managers. The challenge is, and has always been, to identify the best. But has this become more difficult?

Searching for talent

In some ways, finding the best managers has become more difficult. 

“Superior investment skill is down to discipline and process, and that has always been the case,” says Clare Flynn Levy, founder and CEO at Essentia Analytics, a leading provider of behavioural data analytics services to professional investors.

“But in the past, you could get away with not doing it,” Flynn Levy adds. “You could talk about having a great process, but in practice it was not followed to the letter, not documented and not reflected upon.”

That has changed today, and is largely due to improvement in portfolio analysis frameworks, and is reflected in the scarcity of alpha and the pressure on active management fees. 

Still, not all portfolio analysis frameworks are created equal. For instance, Rick Di Mascio, founder and co-CEO of Inalytics, a UK-based portfolio analytics consultancy, argues that his company’s framework has identified a fairly stable cohort of elite portfolio managers, who constantly generate alpha net of fees and share some common traits. 

This is not to be taken for granted, and Di Mascio sees it as a strong argument in favour of active management. 

Active managers underperform against passive peers over all time periods 

Inalytics has identified an elite group of alpha generators thanks to deep analysis of an impressive database of more than 1,100 actively managed equity portfolios representing over $1.2trn (€1.07trn) of assets, with a track record spanning 24 years.

Di Mascio founded Inalytics after holding several senior positions in the institutional asset management industry. Most notably, he is a former CIO of the UK coal industry-wide pension scheme and was previously a senior executive at Goldman Sachs Asset Management. 

Inalytics uses a patented technology called DECSIS to analyse managers’ buying, sizing of trades  and selling decisions. Deep behavioural analysis of the data, which is provided by clients who want to understand their portfolios better, has led his team to conclude that pure investment skill not only exists but can translate into consistent outperformance.  

In 2022, Inalytics found that out of the 752 portfolios that had a track record of more than three years, 84% outperformed their benchmarks, delivering an average annual outperformance of nearly 4%.  

The mean annualised outperformance of the entire database is just shy of 2% per annum, gross of fees and transaction costs. 

One important takeaway from Inalytics’ research is that elite managers tend to run concentrated portfolios. Overall, the consultancy’s database of outperforming managers is very diversified, notes Di Mascio, but individual portfolios are often concentrated in a limited number of stocks.  

Other than that, how do they do it? They have superior research processes and superior judgement in terms of sizing, rebalancing and closing of positions. 

The last element – a manager’s selling decisions – turned out to be the crucial one. This is the main finding of an academic paper titled Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors, co-authored by Di Mascio, which was published by the Journal of Finance in 2019. 

The paper won first prize in the Dimensional Fund Advisors Prizes last year and shows that even skilled stock buyers exhibit selling habits that can harm performance.

Flynn Levy of Essentia Analytics echoes Di Mascio’s finding about selling decisions. “There [are] no two managers whose behaviour looks exactly the same, but a very common thing is the tendency to hold on to losers for too long,” she says. “And that can really make or break performance.” 

Flynn Levy’s company’s methodology is based on the behavioural analysis of portfolio managers’ decisions and their outcomes. It focuses on key metrics such as a portfolio manager’s hit rate – the percentage of decisions that add value to portfolios – and their payoff ratio, or the relationship between the average outperformance of outperforming positions and the average underperformance of underperforming positions. 

Essentia has established a ‘Behavioral Alpha Benchmark’, which scores managers based on whether their decision-making added value. Managers who score above 50 are 1.5 times more likely to outperform their benchmark over the next 12 months compared with those who score below 50, the company found. 

“The research has shown that people who have made skilled decisions in the past are more likely to make skilled decisions in the future,” says Flynn Levy.

She contends that the tools used by consultants and investors to assist in selecting managers lack the predictive power of more sophisticated behavioural frameworks. 

What investors want today

Given everything investors know about individual managers, and their ability or lack thereof in terms of delivering alpha sustainably, how should they approach portfolio construction?

Chris Redmond, global head of manager research at Willis Towers Watson, says that it is partly about being aware that some managers will do very well and some will struggle. 

“We recognise that timing styles is incredibly challenging, and a more robust way to deliver value over a cycle is to deliver more balanced portfolios,” Redmond says. “Critically, they will include a combination of things that most people pursue, like value, growth, large caps and small caps; but it will also include momentum.” 

Asset allocators are gradually acknowledging that the ability to follow trends is an important skill that does not need to inform every single manager’s decisions, but needs to be reflected in portfolios, Redmond adds.

“One of the reasons that our portfolios have fared well is that, for good or bad reasons, some of the long-only managers that we utilise come from more of a hedge fund background,” he says. 

“Their skillset tends to incorporate a slightly shorter-term trading component, and, as such, they have fared better in picking up on some technical factors that have allowed them to protect their portfolios in a very choppy market environment,” Redmond says. 

That is not to say that investors should expect their value or growth managers to change their style. “It is about acknowledging the fact that each manager is appointed as part of a diversified portfolio where they play a very specific role, and ensuring that when combining each style, investors truly understand the biases that exist within it,” he says. 

And that includes a bias towards long-term fundamentals. There is no way around the fact that in the current environment, an acute awareness of the technical, short-term factors driving markets is necessary. 

Aon’s Stork shares a similar view. He says the company continues to rely on strategies that fit into traditional style buckets such as value, quality, growth or low volatility, but at the same time there is an increasing appetite for rotational managers. 

“By that, I do not mean managers that drift away from their style,” he says.

“But we do find use cases for managers that are a bit more opportunistic within their own investment style. They might have a concept of quality investing in terms of the characteristics they look for in stocks. 

“If they are more adaptable in that approach, more willing to evolve as the market moves, and more opportunistic in how they define quality, then they will have a greater ability to outperform. 

“And we have seen that materialise in the active managers that we work with in our portfolios,” Stork adds.