The main criticism of active management is that the cost of performance is expensive relative to passive investing and that most active managers underperform. But funds which have a high “active share” typically outperform. “Active share” defines how similar or different the securities in a fund are from its benchmark.
The stresses of a low-return world have challenged the established investment doctrines of asset managers, regulators and investors alike, not least for traditional active managers.
The main criticism of active management is that the cost of performance is expensive relative to passive investing and that most active managers underperform. While the bull market of the 1990s lifted all boats, the following decade has been characterised by disappointment and a fundamental revaluation of risk – and what might constitute safe havens.
UBS, looking at the evolution of the fund management industry in October 2012, explained the back story as to why what had happened in the 1990s has affected what is happening today. They explained that no real returns on equities, since the peak of the dot-com bubble in 2000, have undermined faith in the “equity risk premium”, one of the central tenets of asset managers some decades ago has combined with the end of the secular bull run in bonds approaching its natural limit.
Critics of the passives’ claim that 85% of all mutual funds underperform point out that this unfairly puts all non-passive investments in the same bucket. These funds will include a vast number of closet index funds which may have been so defined by their very purpose.
An article, “Is portfolio theory harming your portfolio?” (Scott Vincent, 2011) challenges the definition of risk offered by modern portfolio theory (typically tracking error). Vincent reasserts that active managers of concentrated portfolios persistently outperform indices.
Over the past decade, few thought leaders and academic papers have been presented in the defence of active management. One notable exception has been Professor Martin Cremers, formerly of Yale, who has written extensively on his calculation of “active share” as a measure of what good active management should be all about.
Aberdeen has no problem with the principle of passive investing. We do however have a problem with “closet index” funds, typically with low tracking error. When critics of active management talk about 85% of funds underperforming, they group all funds that are not passive in the same pigeonhole. But funds which have a high “active share”, a definition that leans to our investment style, typically outperform. “Active share” is the measure that defines how similar or different the securities in a fund are from its benchmark, expressed in terms of a percentage. That is why Aberdeen stresses that we are benchmark-aware, not benchmark-driven.
In addition, Aberdeen’s active equity portfolios are typically concentrated, which in turn offer a different risk profile to index. Lessons from the 2008 financial crisis, where all major asset classes fell (once expected to behave differently) led to changes how managers managed multi-asset as well as equity funds. In previous times, multi-asset funds typically had a fixed percentage allocation to equities and bonds. This traditional “balanced fund” model, often typically with a fixed 60/40 weighting, was found to be unsuccessful during periods of high volatility and lower returns.
The main criticism of active management is that the cost of performance is expensive relative to passive investing and that most active managers underperform. But funds which have a high “active share” typically outperform. “Active share” defines how similar or different the securities in a fund are from its benchmark.
Champions of a new multi-asset model concluded that in trying to generate a steadier return, it makes sense to focus less on outperforming a benchmark or peer group and more on delivering specific, pre-determined objectives, now known as dynamic asset allocation. This redefining of what investors understand as risk is significant. Passive funds have a role in eliminating manager risk, but investors are still exposed to market risk. Active management aims to reduce the risk in downturns; indeed it is this downside component that makes them an attractive option during periods of low returns and volatility.
We also believe genuine diversification is important in reducing risk. The role of the active manager is to conduct rigorous first-hand research in order to fully understand what drives the underlying investment, i.e. understanding its risks and where it gets its returns. As a manager with a global perspective, Aberdeen aims to reduce risk by finding investments for portfolios that in aggregate will reduce risk by lower correlations.
Indices, by contrast, can over-concentrate in specific sectors depending on the market cap make-up of the country (so for example the UK equity index is overweight in banking, oil and services). Index funds can be good for markets that are efficient, but do rely on liquid markets and indices with a broad exposure of large capitalised stocks, like the S&P 500. In many emerging market stock markets, capitalisation-weighted indices can however overweight exposure to a particular dominant sector or even individual companies. This can carry its own distortions. And passive funds, although cheaper, typically underperform their indexes because they carry some costs and of course are unable to outperform by their very nature.
To summarise, active management is here to stay, but it will have to earn its keep as what is being known as a “high alpha” business. As management consultants Casey Quirk have said, there is no role for expensive beta in the active management suite; margins are getting compressed and there is no interest in expensive beta not offering performance.
