A Case for True Active Management
Last year marked a new record (surpassing 2013’s record) for inflows into ETFs – or passively managed investment funds – likely approaching $140B. As Figure 1 suggests, this staggering number is a continuation of recent trends towards passive equity investing, and away from active management.
Figure 1. Massive Fund Flows to Index Funds (1988 – 2014)
The argument that supports this shift in market share, as advanced by Vanguard and others, relies on an analysis of the universe of active managers and their risk-adjusted returns, net of management fees. According to the analysis, investors are better off passively tracking equity benchmarks rather than trying to select managers who will outperform those benchmarks after subtracting management fees.
We think this analysis misses a crucial distinction between active managers, and is therefore flawed.
The case against active management includes too broad of a universe of active managers. Instead, we segment the universe of active managers on two factors:
Active Share (or the percent of the portfolio that is not identical to the benchmark index)
Standard Deviation of Monthly Returns (a measure of total risk - the amount of variability in monthly returns).
Our analysis suggests that managers with the highest active share and below-average standard deviation outperformed passive investment vehicles and generated better risk adjusted returns (as measured by Sharpe Ratios) since 2007. We refer to this most effective subgroup of the active manager universe as “Skilled Managers.”
Redefining Active Management – The Search for Skilled Managers
In order to segment the universe of active managers, Redwood categorized each Large Cap Core manager in the Evestment Alliance database into one of four categories based on their active share and standard deviations. Those four categories are depicted in Figure 2.
Figure 2. Categorization of Active Managers
We then measured the average annual returns, excess returns (vs. the S&P 500), and standard deviations of returns of the managers in each category from 2007 - 2013. Active share data was only available for the period from 2007 forward. For a more detailed account of the methodology of the study, please see endnote 1.
Skilled Managers Have Outperformed Passive
The results of the analysis suggest that Skilled Managers generate average returns in excess of the S&P 500 and associated ETF/Index funds. A similar pattern holds true for Sharpe Ratios; Skilled Managers deliver materially better Sharpe Ratios than do the S&P 500 and associated ETF/Index Funds. The detailed results are displayed in Figure 3.
Figure 3. Large Core Universe Performance Comparisons (Net) - 2007-2013
Investors Have Picked the Wrong ‘Active’ Managers
Finally, we analyzed the market of each category of manager in the Large Core Universe. To our surprise, we found that Structurally Flawed managers represent the largest single category at 43% of the universe by assets, while Benchmark Huggers represent 31% (see Figure 4, below).
Figure 4. Assets in Large Core Universe (2013)
Three Striking Implications
By failing to distinguish between active managers on Active Share and Standard Deviation, the argument in favor of passive management understates the risk-adjusted returns of “True Active Management.”
Investors are concentrated in the lowest value-added strategies within active management. More than 40% of actively managed Large Cap Core assets are invested with Structurally Ineffective managers who demonstrate low active share while still taking above-average risk.
Active managers who are able to construct portfolios with high active share and maintain attractive risk parameters – Skilled Managers – have a structural advantage over their active management peers.
We believe that as investors migrate towards passive management they are proverbially throwing out the baby with the bathwater. While the broadest definition of active management underperforms passive, managers who are able to construct differentiated portfolios with attractive risk parameters have actually outperformed over the 7 years ending 2013. Investors who are selecting active managers would be well served to add a focus on Skilled Managers to their manager selection process. By focusing on these characteristics, investors can improve their chances of reaching their long-term investment goals and outperforming the market.
Methodology: The Large Cap Core universe is defined as all managers in the Evestment Alliance database self-reporting as a Large Cap Core manager. High active share strategies are defined as greater than or equal to 80% and low active share strategies are less than 80% relative to their respective Large Cap Core benchmark (e.g. Russell 1000, S&P 500). Low standard deviation strategies are those with a standard deviation below average compared to the average Large Cap Core manager. High standard deviation strategies are those with a standard deviation above average compared to the average Large Cap Core manager. Net of fee analysis was completed using net of fees returns as reported by the manager to the Evestment Alliance database when available or, when not available, gross of fees less 55bps to account for the management fee. Redwood utilized the 55bps fee schedule because it was the average in the Evestment Alliance database.