Manager Selection: Active management still valid

Jakob Møller Hommel and Casper Hammerich  argue that actively managed funds should not be written off yet. The key is to choose and monitor active managers with care 

At a glance

• Investors have started to question even the concept of active management.
• The key to selecting active managers is having a dynamic approach to identifying, selecting and monitoring them.
• Emerging debt shows some of the limitations of passive management.
• The existence of many different ways into this asset class makes it crucial to understand how active managers can exploit market inefficiencies.

The idea of adding value through actively managed funds was an important theme with many asset owners during 2016. What was perhaps most surprising was the growing trend for investors to question active management. 

Such sentiment is rooted in past research indicating that active management fails to provide better returns than the market. The criticisms are given added weight by the low level of yields at present. As a result an increasing number of investors is either cutting the costs of active fund management or, alternatively, moving allocations into index-linked funds. 

In our opinion, the claim that actively managed funds as a whole are failing to outperform the market should be qualified. The key to success in selecting active managers depends on having a dynamic approach to identifying, selecting and monitoring external managers.

There is no doubt that the discussion of active versus passive management originates from research undertaken in equity-related investments. That said, it is also clear that passive investing within fixed income is raising its profile in the minds of investors.

Some larger passive managers have pointed to the failure of many credit managers to deliver consistent alpha in the recent years. Investors’ growing sentiment towards passive funds within credit was clearly illustrated last year when significant inflows to US high yield exchange-traded funds (ETFs) were observed. As a negative side effect, the large inflows increased the difficulties in outperforming the benchmarks for many actively managed US high-yield funds in 2016.

normal distribution of excess returns among active asset managers in emerging market debt

Also, in terms of emerging market debt, headwinds from recent global economic developments, starting with the 2013 taper tantrum, caused market turmoil. Active emerging market debt managers face challenges such as high volatility, the slowdown of the Chinese economy and the weakness of oil prices. With the benefit of hindsight a passive approach would probably have performed better in last year’s market.

But several caveats should be stressed before losing faith in active management and embracing passive management. These are well illustrated by emerging market debt. The range of passive solutions in this market is still limited and the quality of passive approaches is not yet fully tested in different market environments. 

Second, and perhaps even more important, emerging market debt is still an asset class filled with significant inefficiencies which passive managers are ill-equipped to harvest. As illustrated in the figure, although emerging market debt managers generally have delivered benchmark returns, the dispersion of excess return is high. This indicates that there are still opportunities to create alpha. The question is what characteristics make a strong external manager?

The most obvious challenge is capturing inefficiencies. Identifying, selecting and monitoring managers is resource-intensive. It is vital to understand the interaction between team, philosophy and investment process. Recent years of dispersion in excess returns proves the importance of having a well-documented method of selection.

First and foremost, investors should have a clear understanding of a manager’s investment philosophy. This is an area that sometimes seems under-appreciated by investors. Specifically, in the case of emerging market debt, the fact that managers can pursue many different routes in this asset class makes it crucial to fully understand what inefficiencies a manager is looking for and, more importantly, how these inefficiencies are captured. A value-adding characteristic of a manager’s philosophy is the ability to understand the development of the emerging markets in a global context. This enables the manager to develop a strategy which is better able to take advantage of global external factors. 

Such an approach should be combined with a thorough understanding of the specific countries both inside and outside the benchmark. Furthermore, it can be beneficial for investors to consider managers that are not restricted to official benchmark constituents, but who also consider countries with similar risk characteristics.

Second, investors should have a sound understanding of the structure of the asset manager’s investment process. Investors should be able to identify managers with comprehensive investment processes and sufficient resources to support them. The existence of a clear and credible ideas-generation process that enables identification of opportunities in the entire investment universe is crucial. Having a structured and well-documented research process increases the likelihood of extending strong past returns into the future.

An increasingly important point in the current years of high market volatility has been the managers’ understanding of the inherent risks in the strategy. An autonomous team should, in our view, manage the risks involved. Such a separation from the investment team allows for a questioning of the portfolio manager’s decisions in a clear and unbiased environment. 

Finally, managers should have a transparent and understandable portfolio with a reasonable degree of differentiation and not too high a turnover.

Investors and asset managers should consider the implications of the inflows not only into liquid equities but also liquid fixed-income. The question is whether these shifts should be seen as temporary headwinds or as an added inefficiency that could help active managers generate long-term alpha. 

Jakob Møller Hommel and Casper Hammerich work at Copenhagen-based consultancy Kirstein. They advise institutional investors and asset managers on investment and strategy

Readers' comments (1)

  • Although I don't have the necessary data to prove or disprove it, the whole subject of assessing active manager's returns against their benchmarks makes me wonder about the quality of the data and the process. We know there are thousands of active managers, but how many of them are legitimate players? When every little bank (and big bank) or wealth manager creates a “me too” fund that goes into the data pool, we should be asking: is this a legitimate attempt to provide alpha? Or is it just a way to capture fees when the intention of the manager is merely to make sure not to do so badly versus the market that their investors, many of whom may be captive, bail out? Perhaps a better way to assess active managers is to first remove those firms with no clear incentive to provide alpha, those who can afford to limp along with so-so returns because fund management is not their bread and butter. Those who can afford to put out a fund that fails, that they then scrap and reinvent and don’t fear to suffer any reputational damage? Perhaps it can also make sense to examine the real goals of the managers to remove those who are only attempting the mildest outperformance over their benchmarks. Just a thought.

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