Top 400: Active management - tipping the odds in your favour
The question of active versus passive management has long faced investors, argues Roz Amos
Is active management, where one pays higher fees hoping that the manager's skill will generate returns greater than those of the market, merely a triumph of hope over experience, or is it a sensible approach? What about when there is no clearly defined market?
In broad terms, there are two types of return available: the market return (beta) and the return that a skilled manager can produce above the market return (alpha). In many markets, such as mainstream equities and bonds, it is fairly straightforward to calculate the alpha and beta for a manager. Ideally, alpha should be calculated after the deduction of all fees, costs and taxes. If a manager beats the index before fees but not after, it has failed to create a net benefit for its client. Typically, beta can be bought cheaply through a passive manager while an active manager costs more. When there are both alpha and beta managers in a market and an investor has a limited fee or governance budget that will allow some alpha and some beta management, the key decision becomes where to allocate this budget?
There are a number of factors that we would consider important when determining the active management potential of a market and we set out in this article which areas we believe offer the best opportunities for active investors. These factors are listed in figure 1 and described in more detail below. Considering these factors can help investors to make more informed choices about where to spend their budgets.
As a general principle, we prefer to seek alpha in broader, more diverse markets rather than narrow, homogeneous ones, as these offer a more diverse opportunity set for active managers to exploit. Consider the wealth of opportunities within the global equity market relative to many domestic equity markets, or the global fixed-income market relative to long-dated UK gilts, for example. The opportunity to seek value outside the benchmark index is a positive, as it can allow comparisons between different markets that are not easily made within a narrower universe.
In many markets some participants are not just seeking to maximise profits by investing in the market, but are holding securities for other reasons. There are regulatory reasons, for example, such as the holding of long bonds by insurance companies and pension funds. Many sovereign funds are under either political or regulatory pressure to hold a certain proportion of assets in local markets. In many markets, domestic investors are only able to invest a certain proportion of their assets overseas, which is likely to lead to them holding securities that are sub-optimal in a financial sense. Changes in popular benchmark indices can create forced selling by passive managers, again offering opportunities.
The presence of participants with different objectives and different timeframes also creates opportunities for active managers.
Many factors in a market can lead to asymmetrical information between participants, even in today's world of continuous disclosure and rapid information dissemination. Retail investors typically have less access to information than institutional investors, so the presence of a large retail sector often provides opportunities for institutional asset managers. The presence of brokers and other similar organisations disseminating research also varies widely. In some markets, notably those that are developing, the availability of broker research and analysis can be very limited, so the marginal return to active managers of spending resources in these areas is likely to be greater than in more developed, better covered markets. Other barriers to knowledge, such as cultural differences and language challenges, as well as non-standard reporting, can also enhance the benefits of detailed research.
There are several factors that can impact market efficiency, including the effectiveness of benchmark construction - an index that focuses only on large-cap securities can offer managers a lot of opportunities in the small-cap market, and a government bond index may offer scope for other investments that are not included in the benchmark. Different types of investors may have access to different parts of a market, for example in Chinese equities there is a market for domestic investors and a market for international investors. If a benchmark focuses on one part of the universe and a manager can access both parts they may be able to generate alpha in this way (although we could debate whether this is simply beta in a different form). Another area of inefficiency is time premia - there is significant evidence that in many markets, particularly equity markets, the average holding period for securities is decreasing. In many equity markets the holding period is now less than a year, which should mean that there are more opportunities to add value for investors that have a longer timeframe and are able to see through the noise to better identify long-term value.
Capacity in top-rated managers
None of the opportunity sets in the world are of any use if you cannot find skilled managers to exploit them. There are a number of markets that, on the criteria described previously, ought to offer good opportunities for active management, but where we struggle to find many managers who have the skill-set to exploit them. Global small-cap equities is a good example - the asset class scores very highly on the above criteria, but because of the depth and breadth of deeply specialised knowledge needed to exploit the value opportunities, we struggle to find managers that we believe are able to do this.
There are also markets where there are skilled managers, but due to factors such as market liquidity and size, they have only very limited capacity, and periodically there will be no available, highly skilled managers in these markets at all. The identification of an opportunity set is therefore not enough - there must be skilled managers available to exploit it.
As already noted, an active manager who beats his benchmark before fees and costs but underperforms after these have been deducted has failed to create net value-added for his client. We believe that the best benchmark is the index return minus a few basis points to reflect the costs of buying the passive market return. However, there are other costs associated with achieving an active return, notably trading and transaction costs, which are typically higher for active funds as they transact more frequently. It is important to note that all trading costs and most agency costs are factored into quoted gross performance numbers, so the manager fee is the main hurdle to overcome.
Unsurprisingly, the markets where there is the lowest cost drag are the developed, large and liquid markets, both equity and bond. There can be market-specific factors that distort this, such as stamp duty on share purchases. This makes turnover expensive in these markets, reducing the attractiveness of active relative to passive management.
So where should you go active?
Based on our criteria outlined above, we are able to score many major markets on what we believe to be their current potential for active management. Within equities, we see great potential for global equity managers, as the breadth of this opportunity set is a great advantage in making relative decisions. There are also other areas, such as Asia-Pacific and US small cap equities, where a deep pool of managers combined with market inefficiencies means that we would expect to see good returns generated by in-depth research.
Within the bond markets, we see the strongest alpha potential in the less efficient and transparent markets, such as high yield and emerging market debt, where we would expect experienced and high quality managers to be able to add significant value over the market. Within markets where alpha and beta are less clearly defined, such as private markets and hedge funds, we believe that the costs inherent in many structures are likely to erode alpha significantly, despite a good universe of skilled managers and broad opportunity sets. Our view is that investment into direct private market and hedge fund products (rather than via funds of funds) offers the best opportunity for alpha generation across all asset classes, but that it is key to focus on fees and costs in these areas.
Many institutional investors struggle when deciding whether they want active or passive management, or a mixture, and if a mixture in deciding where to do which. We believe the factors described here can help with these decisions and maximise the likelihood of success for an informed active management programme.
Roz Amos is a senior investment consultant at Towers Watson