Value of active management lies in 'market breadth', not efficiency
EUROPE - The performance of active management has nothing to do with market efficiency and everything to do with "market breadth" in terms of investment opportunities, according to a recent study by Dutch active asset manager Robeco.
The greater the number of independent investment opportunities, the greater the potential for active manager outperformance and vice versa, said Hans Rademaker, member of Robeco's management board, as he presented the research report during a recent seminar on active investment management in Rotterdam.
Robeco analysed the performance of active managers in a variety of markets, including the US and European bond and equity markets over a period of 20 years.
The research shows that, on average, active managers underperform net of fees.
However, 20-40% of managers do, in fact, show persistent outperformance relative to a portfolio of investable index funds.
So some managers do outperform, and some do so with at least some persistence.
The tricky part is selecting winning managers and avoiding losers, Rademaker said.
"If you don't believe it's possible to predict the winners, or if you don't have the budget or resources to invest in a rigorous selection process, you're probably better off opting for passive management."
Which is not to say passive investment management is a picnic, he added.
"You have to realise that passive investments can be incredibly complex," he said. "And some index products aren't as passive as they may seem, considering their significant risks of underperformance."
Good active managers are hard to find. Passive management is no panacea. What else is new?
These are hardly surprising conclusions. But the Robeco research did, in fact, yield some surprises.
One finding, for instance, goes against the grain of conventional wisdom, which holds that active management is no use in efficient markets, where information is quickly disseminated and reflected in pricing.
Supposedly, successful active managers capitalise on information that they are privy to while others are behind the curve.
Consequently, it is commonly assumed that active strategies thrive on inefficiencies and fall flat in efficient markets.
Not true, says the Robeco research.
"The added value of active management is not correlated to market efficiency," said Rademaker.
Even in very efficient markets, such as the US large-cap equity market, active managers can deliver outperformance.
Conversely, market inefficiency is not indicative of active manager success - the research shows no evidence of any indication that active strategies are more likely to outperform in inefficient markets such as high-yield corporate bond markets.
Market efficiency is no significant indicator - but market breadth is, said Rademaker.
"The potential for outperformance of active managers turns out to be higher in markets with many independent investment opportunities and lower in markets with fewer independent investment opportunities," he said.
Another interesting research finding is that market breadth is not constant.
The number of independent investment opportunities within a specific market varies over time.
Rademaker said: "The government bond market, for instance, offered very few independent investment opportunities for a long time. But the number of independent opportunities has increased quite a bit over the last few years, changing the picture with regards to whether it makes sense to opt for active strategies in this area."
So assessing market breadth gives investors an instrument to help them determine when and where it might pay to employ active strategies, and where it might be better to opt for passive management.
"This leads to a more dynamic approach to the choice between passive or active management" concluded Rademaker.