This means that not only is the additional risk not rewarded, it is actually punished. “For long-only managers, it can be difficult to deliver consistent alpha with a tracking error target of more than 2.5 per cent,” according to Sean Fenton, portfolio manager at Tribeca Investment Partners. “If you go beyond that, you have to have the ability or capacity for active extension (such as 130:30 funds).” A study of 51 active long-only managers in the Mercer Australian Shares survey for the five years to May showed they had a median tracking error of 3.7 per cent (see table on p.19). Those with below-median tracking error returned 8.2 per cent for the period and those with above-median tracking error returned 7.9 per cent.
The active extension managers produced 8.4 per cent for the period. Tribeca’s Fenton says that super funds should be looking to choose a manager which can generate alpha through a cycle. To switch to indexed portfolios just because of a belief that the beta return will be higher than normal is too short-termist, he says. While high tracking error and high conviction can be the same, they are not necessarily so. Intech’s Needham admits that the industry’s move to high conviction managers was probably a wrong turn and he predicts a greater emphasis on portfolio construction in the future.
Fenton, who runs Tribeca’s active extension fund, the Alpha Plus Fund, says that the asset consulting fraternity needs to shoulder some responsibility for under-performing concentrated managers because they pushed the managers into a space that many should not have gone. “The best way to reduce the constraints on managers is to allow them to short stocks too,” he says, “rather than force them to have narrower benchmark-unaware portfolios, which will inevitably blow up.” He says there are probably not as many opportunities in Aussie equities currently as there were at the beginning of the year when risk aversion reached an extreme level.
“If you were able to get comfortable that the world was not going to end then there were lots of opportunities to take on risk that had been priced down. And there were a lot of hints that the situation would normalise, such as credit spreads coming back.” Active managers, of course, should be happy to coexist with passive managers. The more investors who move to index funds the easier it gets for active managers. Markets could not function if everyone was indexed. Just as active managers rely on beta to provide momentum and mispricing opportunities, indexers need stock-pickers to keep the market relatively efficient. “If passive management becomes too popular, marginal price-setting becomes determined by cashflows rather
