Active management: more than a stopped clock | Characteristics


As the saying goes, even a stopped clock is right twice a day. And with a seemingly growing number of institutional investors finding long-term outperformance elusive and questioning the potential rewards of active management, any outperformance that does occur is often greeted with cynicism and expected to be met. it is temporary.

The move towards passive management has been one of the strongest and most consistent trends among institutional investors over the past decade or more.

Moreover, with high stock market valuations, a significant concentration of indices and a potentially messy transition to a low-carbon economy, isn’t it time to try to breathe new life into the debate on the role of the elusive and rare managers? assets that are really outperforming?

Numerous studies show that less than 50% of managers surpass the average of their peers. Of course, the reality is much worse after fees subtract, and our analysis currently shows that only around 30% of active equity managers outperform their benchmark, net of fees, across the universe we are looking at. .

However, what matters is the likelihood that a chosen individual manager will outperform over a period of time. Therefore, the debate should revolve around the ability to reliably identify managers among that 30%, the criteria for selecting active managers, and approaches to manager selection and portfolio construction that maximize the likelihood of success.

A manager search process involves selecting thousands of active equity managers for detailed review from the entire global universe of 16,850. In our case, that involves both proprietary tools and well metrics. known such as the active part, which measures the difference between the assets of a portfolio and those of its benchmark index to filter the “benchmarkers” and those for which any gross commission the outperformance is effectively paid to the asset manager in the form of commissions. Such an initial process cuts about three quarters of the universe. Among the remaining group of credible active managers, the probability of outperformance after fees can reach 50/50.

The application of an in-depth manager research process leads to the emergence of a notable probability of outperformance. In our experience, the chance of beating the benchmark can approach two-thirds.

An unnecessary dead end in the active management debate is the simplification that when you find an active outperformer, they will always achieve such results. The truth is, active talent and investment teams go through a “skill cycle” and therefore there is a need to constantly reassess them, even with a long-term perspective and approach.

Investors should recognize a more realistic goal (of perhaps 70% odds) in selecting managers to consider how winners and losers can work together to form a portfolio.

Understanding this is one thing; Identifying it requires considerable resources and a robust process.

We also work with managers to proactively create mandates and products that isolate and leverage their particular skills, such as high active value focused stocks for qualified stock pickers. The objectives here are to maximize the potential candidates of the universe. For example, we observe that some skilled stock pickers have not launched highly active concentrated equity strategies and need to be pushed.

“Talent and active investment teams go through a ‘skills cycle’ and therefore constant reassessment is required, even when applying a long-term perspective and approach.”

Focusing on sustaining long-term competitive advantages involves significant time in understanding the culture of organizations, the alignment between different stakeholders and how they manage to create effective teams capable of growing and evolving. .

It is only through a combination of top-notch asset managers and generally longer holding periods that the odds of outperformance become compelling. Recently, around 67% of these top-rated, unrestricted, best-idea mandates have outperformed their benchmark.

Diversifying the sources of return across styles, sizes, industries and geographies ensures independent ratings, and removing teams with similar ideas further reduces the total number. Combining different equity portfolios focused on “best ideas” with standalone outperformance ratings of around 67% in this way can create an overall portfolio with outperformance ratings above 90%.

The combination also has the advantage of being “style agnostic” by definition.

“The risk associated with a passive investment in equities is currently high, arguably greater than that of a well-managed portfolio of active equity managers”

Its success relies on the wisdom of the crowds, but not the whole crowd – rather, a small crowd of “super forecasters” managers who tend to use statistically better information, even if they disagree. where it matters.

Why so active now?

A differentiated and detailed approach to the selection of managers and the construction of the portfolio constitutes a solid structural argument in favor of active management. However, in addition, external factors in favor of active management are also strengthening in 2021. This includes a natural cyclicality, which is already showing signs of backtracking in favor of better results from the best active managers.

Added to this is the recent increased concentration in equity markets, both in terms of composition and contribution to performance. “FAANG” stocks are an increasingly important component of US and global indices and contributed 54% of the strong performance of the MSCI USA index in 2020. Any reversal of this trend would have a major impact on these stock indices. and the passive products that follow them and will likely benefit active managers who seek a wider range of individual sources of return.

The structural challenges of market returns are also likely to suit the skills of active management, particularly the growing financial relevance of climate factors and stewardship.

In such a market environment, a deeper understanding of how a large portion of global portfolios could at least track or diverge from index movements – to say nothing for the entire market itself – is an essential tool. in the arsenal of investment committees. In other words, the risk associated with a passive equity investment is currently high, arguably greater than that of a well-managed portfolio of active equity managers.

Active management is not just a stopped clock. We believe that there is a model that can deliver solid results over the long term, furthermore, there are factors suggesting that active management may be well rewarded in the years to come.

Chris Redmond is Manager of Manager Research at Willis Towers Watson


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