Insto investors question active management
Never before, or at least never in living memory, have super funds faced such uncertainty as in the past 12 months. But with signs of recovery emerging for both markets and the global economy, trustee boards are feeling that it is safe to get back into the water. Most have been sitting on cashflow build-ups and have recovered a good part of their Aussie dollar hedging losses from last year.
The big question now is: what to invest in? If you believe in the recovery and mean reversion then this could be the best beta play of all time. On the other hand, active managers claim the markets represent a stockpicker’s paradise. The old active versus passive debate has returned with a vengeance. SIMON MUMME and GREG BRIGHT report.
Jack Gray and Ron Bird are working together on a paper, for the University of Technology Sydney, which will look at why investors continue to choose active managers.
It’s a strange phenomenon given that everyone has known for years that the average active manager struggles to beat the index after fees over long periods.
The academics theorise about several reasons, from vested interests to hubris. There are periods of years, too, when the average active manager actually does outperform and there are also markets, such as Australian equities, where outperformance of the index seems easier than in others.
But just when you thought the debate had waned and active managers had learned to co-exist with passive, content to see 20-25 per cent of the institutional market tracking the main indices, AustralianSuper, the country’s largest industry fund, announced it would index $3 billion, or half its Aussie equities portfolio, sacking 21 managers in the process. Suddenly the debate is on again. What makes it different this time is the belief that this time it actually is different. The markets fell so far, across the board, that it is clear that they have overshot on the down side, notwithstanding a partial recovery in prices since March this year.
So, if you think most of the money to be made in the near future will come from beta, why pay active fees? Well, in Aussie equities at least, the median manager’s outperformance climbed steadily in the year to March, according to Mercer data, finishing that 12-month period near an historical high point of 3 per cent before fees (see chart). David Carruthers, a Mercer principal, says that there seems to be a notion that active managers tend to outperform more consistently in down markets but that does not hold true at least for Australian equities. “What is true is that active managers do tend to do better when there is a lot of cross-sectional volatility,” he says.
Over the past 12 months the cross-sectional volatility in the Aussie equities market – or dispersion between the best performing and worst performing stocks – has been at its highest level for six years. “But even if you go back two years,” Carruthers says, “I’d still argue the case for active management.” He points out that alpha and beta are not mutually exclusive, but alpha seems to be continuing to rise in Aussie shares. “The numbers show it’s a great time to be active,” he says. “There are times when you’d probably rather be index tracking but now is not that time.” While fees represent a big factor in the active/passive debate, they are not the only factor.
The cost of selecting and monitoring active managers is a concern, as is the possibility of being too diversified such that at the portfolio level the net effect will inevitably be close to index performance. Daniel Needham, general manager, investments, at Intech Investments, says that for big funds it may be difficult to have a meaningful allocation to some active managers because of limited capacity. “For example, a good manager might not want to take on $2 billion at very low fees,” he says. If the fund spreads the money around further, it may then feel that it is not on top of the job of monitoring all the managers.
“Before making the decision to go active, you need to look at the asset class and decide whether you’re likely to be rewarded for being active,” he says. Passive management tends to make more sense in some markets, such as Australian listed property, according to Needham. The listed property market in Australia is very narrow and there is not enough left on the table to be active in it, according to Intech. Credit markets, on the other hand, have asymmetrical risk, with upside limited by the spread.
The index is issuer driven, with more than 10,000 securities, and hard to replicate. Passive credit managers have to have fairly concentrated portfolios. Fundamental indexing, which takes account of various value-orientated factors rather than simple cap weighting, makes more sense in credit markets. Intech has created its own indices in global listed infrastructure, with Vanguard, and global CPI-linked bonds, with Barclays. Whenever there is a trend in investment management a lot of investors inevitably jump on board at the wrong time.
One of the biggest swings to indexing equities occurred in the US in the late 1990s after the five-year US bull market had run. The market subsequently produced three negative years in a row, with active managers outperforming as value came back. Mercer data shows that the trend to so-called ‘high conviction’ managers over the past few years is unlikely to have delivered the sort of returns investors would have hoped for. Higher tracking error managers in the long-only space, which is where high conviction or concentrated managers can be found, have worse performance on average than lower tracking error managers.
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
Jack Gray and Ron Bird are working together on a paper, for the University of Technology Sydney, which will look at why investors continue to choose active managers. It’s a strange phenomenon given that everyone has known for years that the average active manager struggles to beat the index after fees over long periods. The academics theorise about several reasons, from vested interests to hubris. There are periods of years, too, when the average active manager actually does outperform and there are also markets, such as Australian equities, where outperformance of the index seems easier than in others.
But just when you thought the debate had waned and active managers had learned to co-exist with passive, content to see 20-25 per cent of the institutional market tracking the main indices, AustralianSuper, the country’s largest industry fund, announced it would index $3 billion, or half its Aussie equities portfolio, sacking 21 managers in the process. Suddenly the debate is on again. What makes it different this time is the belief that this time it actually is different. The markets fell so far, across the board, that it is clear that they have overshot on the down side, notwithstanding a partial recovery in prices since March this year.
So, if you think most of the money to be made in the near future will come from beta, why pay active fees? Well, in Aussie equities at least, the median manager’s outperformance climbed steadily in the year to March, according to Mercer data, finishing that 12-month period near an historical high point of 3 per cent before fees (see chart). David Carruthers, a Mercer principal, says that there seems to be a notion that active managers tend to outperform more consistently in down markets but that does not hold true at least for Australian equities.
“What is true is that active managers do tend to do better when there is a lot of cross-sectional volatility,” he says. Over the past 12 months the cross-sectional volatility in the Aussie equities market – or dispersion between the best performing and worst performing stocks – has been at its highest level for six years. “But even if you go back two years,” Carruthers says, “I’d still argue the case for active management.” He points out that alpha and beta are not mutually exclusive, but alpha seems to be continuing to rise in Aussie shares. “The numbers show it’s a great time to be active,” he says. “There are times when you’d probably rather be index tracking but now is not that time.”
While fees represent a big factor in the active/passive debate, they are not the only factor. The cost of selecting and monitoring active managers is a concern, as is the possibility of being too diversified such that at the portfolio level the net effect will inevitably be close to index performance. Daniel Needham, general manager, investments, at Intech Investments, says that for big funds it may be difficult to have a meaningful allocation to some active managers because of limited capacity.
“For example, a good manager might not want to take on $2 billion at very low fees,” he says. If the fund spreads the money around further, it may then feel that it is not on top of the job of monitoring all the managers. “Before making the decision to go active, you need to look at the asset class and decide whether you’re likely to be rewarded for being active,” he says. Passive management tends to make more sense in some markets, such as Australian listed property, according to Needham. The listed property market in Australia is very narrow and there is not enough left on the table to be active in it, according to Intech.
Credit markets, on the other hand, have asymmetrical risk, with upside limited by the spread. The index is issuer driven, with more than 10,000 securities, and hard to replicate. Passive credit managers have to have fairly concentrated portfolios. Fundamental indexing, which takes account of various value-orientated factors rather than simple cap weighting, makes more sense in credit markets. Intech has created its own indices in global listed infrastructure, with Vanguard, and global CPI-linked bonds, with Barclays.
Whenever there is a trend in investment management a lot of investors inevitably jump on board at the wrong time. One of the biggest swings to indexing equities occurred in the US in the late 1990s after the five-year US bull market had run. The market subsequently produced three negative years in a row, with active managers outperforming as value came back. Mercer data shows that the trend to so-called ‘high conviction’ managers over the past few years is unlikely to have delivered the sort of returns investors would have hoped for.
Higher tracking error managers in the long-only space, which is where high conviction or concentrated managers can be found, have worse performance on average than lower tracking error managers. 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 hold as much as 30 per cent of their portfolios in Aussie equities, and these portfolios are predominantly actively managed, most of their active risk is driven by investments in the local share market. “We want exposure to Australian equities – but not an equally high exposure to active managers,” Rogers says. “Indexing some Australian equities unleashes your risk and fee budget for where the opportunities may be far greater.”
While the lion’s share of risk budgets lie with active domestic managers, outperforming managers pursuing global equities, high-yield or hedge fund strategies may not be being given enough risk. Rogers says: “If Australian equities managers don’t do well, it undermines these balanced funds. So let’s index some of the Australian equities portfolio and separate out where else to take risk and pay for active management in the portfolio.” This could mean buying active exposures elsewhere or pumping more money into other asset classes for beta reasons. “It’s too expensive to play every asset class in active, so we need to start optimising how we play.”
Super funds can accommodate and profit from complex strategies, but at which point does the search for further active talent become impractical? “Finding the seventh-best Australian equity manager – how does this ultimately benefit members? The incremental benefit for the investor in a balanced fund for finding the next best new manager is a handful of basis points as opposed to product innovation or further sources of diversification in the portfolio,” Rogers says. He expects that new alpha sources sought by funds will be largely funded by Australian equities portfolios, diminishing the long-run home country bias.
“Half-active, half-passive is not a statement of diminished confidence in the active management definition of delivering good risk-adjusted returns, but is rather a statement about wanting to take those opportunities where they can best be taken, and not to be loaded up on Australian equities,” he says. Believing that markets are inefficient, ipac is searching for managers that can exploit them, “but we want to play it more cleverly and in a more diversified way”, Rogers says. Therefore, at ipac and other institutions, “Australian equities will be the incremental source of funding for new stuff,” Rogers predicts.
“We’d like to portray it as a constant value-add, but in reality, competition and the nature of the economic environment determine how big the opportunity for active management ever really is,” says Rogers. BEAR MARKET BATTLELINES The crisis has done little to alter the long-held battlelines fronted by proponents of active and passive investing. Many active managers, analysts and consultants say that it’s not a good time to be indexing; beta sellers say that, in the end, the market always outperforms stock-pickers.
For those funds taking big bets with passive management, Fiona Trafford-Walker, Frontier Investment Consulting’s managing director, says the cost benefits of a beta-tracking exposure should be weighed against the prospects for active management in today’s volatile market. “If active managers were ever going to make you money, now is the time they will be doing it,” she says. Rogers and many others agree. “In the last five years, so many people were trying to eke out that active return, and killed off the opportunities.
The cycle has now turned, and a lot of that money has left the market, and the opportunity to outperform has expanded,” Rogers says. “The combination of fewer players, more uncertainty in the economic environment and dislocation in prices cyclically sets up significant opportunities.”
Intech’s Needham lists four factors which combine to make the current situation look good for active managers: return dispersion is above average and this is historically associated with higher excess returns valuation spreads are very high the cycle has moved from low breadth of market to above average breadth of market, and earnings expectations are below average, which means it is as good an environment for growth managers as it is for value managers.
Some observers, however, are not easily taken by the talk of opportunity. “Stock-pickers always say it’s a stock-picker’s market,” Gray says. “But macro issues – to get them right and hedge against them – are more important.” In a research note to clients, Ross and other quantitative GSJBW analysts urge institutions to buy more risk
through specialist active strategies, such as small-caps, and exploit peak levels of valuation dispersion among securities. Showing conviction, the analysts assert: “We believe that equity markets currently lack the efficiency that would justify passive allocations”. It is not the time to load up on beta, Ross says. “There will still be a lot of stocks in the ASX200 that are sub-investment grade – active managers will add as much return from avoiding bad stocks than picking good ones.”
The GSJBW analysts say the median active manager of Australian equities returned about 1.5 per cent more than the benchmark in the current downturn, and about 75 per cent cleared the index, as top-quartile managers delivered, on average, 5.5 per cent of alpha. They earn their performance fees. And by avoiding poor stocks while price dispersion is so amplified, they will continue to do so.
GSJBW sees the price dispersion amid the best and worst-performing shares as a proxy for the opportunity set available to active managers. In 2008, this gap widened to its greatest since 1992. These wide spreads between stocks represent major inefficiencies that, if played right, provide good returns. In this market, “fundamental analysis of a company’s returns and ability to stay in business are more important than ever” for active managers.
Due to deleveraging and revisions of corporate earnings, an “abundance of mispricing opportunities” lies in the Australian market. And there are more corporate casualties, and therefore stock-specific risks, to come. “We favour more tracking error than less in an environment where we expect to see above-average levels of default by current index constituents,” GSJBW says. Specifically, quantitative managers, who suffered in 2008 as markets delivered and earnings revision signals proved unreliable, should benefit from the withdrawal of offshore hedge funds and proprietary trading desks, leaving room for survivors and entrants.
Value managers, who were hurt by the weakness of financials, are well placed to buy decent stocks dumped by distressed investors as about half the market trades below book value, but investors will rely on the good managers to avoid value traps. Covered-call strategies, in which a manager sells call options against an underlying equity portfolio, can beat the index in times of high volatility, but usually break even or slightly underperform during rallies. Increasing allocation to index managers right now is precisely the wrong thing to do, according to Nigel Douglas of van Eyk.
Current and expected volatility will produce opportunities for active managers, while exposing their skill. He says alpha is more likely to be found in concentrated portfolios. The managers recommended by van Eyk display a degree of active risk of greater than 3 per cent away from the benchmark. Academic research for US equities finds that in the long-term, passive management outperforms, but that in periods of volatility, active strategies press ahead. Frustratingly though, such performance from active managers is rarely persistent.
In Indexing Versus Active Mutual Fund Management, Rich Fortin and Stuart Michelson test which method outperformed the US market in the 25-year period between 1976 and 2000. It compared the returns from various types of equity and bond funds on both a total and after-tax basis. Overall, apart from small-cap and global equity strategies, index funds outperform on both a total return and after-tax total return basis. But when economies were entering or emerging from recession, active managers took the lead, outperforming during the 1979-82, 1991-93 and 1999-00 bear markets and recoveries. But the overall results, smoothed over the years, iron out these short-term bursts.
The academics acknowledge that their results carry a strong survivorship bias, helping the active managers’ results as lacklustre mutual funds died out within the study period. But nor does it identify the minority of active managers that persistently beat the index, to the benefit of their investors. Christopher Phillips of Vanguard attempts to go one better for the passive camp in more current research indicating that active managers do not always successfully guide portfolios through bear markets, and if they do, their performances are likely to be one-time wonders.
In 2009’s The Active-Passive Debate: Bear Market Performance, average excess returns show that in four of seven US bear markets since 1970, active managers failed to outperform the index, and performance was inconsistent immediately after bear markets. It observed that a majority of active managers beat the market in three of seven US bear markets and in three of six bear markets in Europe. “Success by a majority of funds did not carry over from one bear market to the next,” Phillips writes. However, each bear market produced its outperformers: “it’s also true that in each bear market a group of active funds did outperform”.
Despite his scepticism towards the active camp, Jack Gray does not believe that passive management provides a comprehensive solution to funds’ needs. He says: “You don’t want total indexing. It’s just momentum: it prices up securities and causes them to get beyond fair value.” It would also mean that promising companies, or those undergoing a turnaround, can be shouldered out of investors’ view by big names in the index. “From a market perspective, if you’re a passive investor, you think you’re not making a decision – but you are.
In 1999, you were making a 30 per cent bet on technology stocks,” Gray says. “In 1980 it was oil. And tech and oil bubbles were cyclical problems. As long as the market is broadly diversified, you’re getting cheap beta. But there is a timing aspect.” Gray, whose research with Ron Bird is looking at investor attitudes to active and passive management for the Centre for Capital Markets Dysfunctionality, says managers hold an information edge over institutions in the capital allocation game.
He says: “This is a market where there is a massive information asymmetry. Super funds know very little about what managers are doing and how they’re doing it. People buy things on trust and good stories – and we can all tell good stories. “There is very little performance persistence beyond a couple of years. We know that, but managers still say, ‘I can do it’.” If funds are committing to active management, they should be prepared to do so with conviction, advises Ross at GSJBW. “Not enough pension funds take enough risk.
They think there’s a free lunch and that you can over-diversify the portfolio and outperform. If they believe in active management, there’s no point diversifying their portfolio to the point where it takes on the semblance of an index. Given the wide ranges of opportunities that now exist across markets, they should reduce diversification and take on more risk.” THE INFLUENCES OF AGENTS “Active management outperforms, but you can go overboard by having too many active managers,” Turnbull at LGS Super says, commenting on the tendency for some funds to overpopulate their portfolios with stock-pickers.
One much-needed development in the super industry, comments an institutional adviser who declined to be named, is for funds to develop deeper internal resources and stronger relationships with fewer active managers, and rely less on consultants and other intermediaries while designing portfolios. The adviser comments that portfolios have become too complicated – not in asset class exposures, but in the length and variety of manager line-ups – due to the asset consulting model used widely here, which was imported from the US.
It recommends allocations to a wide range of active managers to diversify risk and tap into further alpha exposures, which works in the US because the market is deeper and the index is less concentrated. However, long before AustralianSuper made its beta play, Frontier Investment Consulting’s base position was that clients should have between one-quarter and one-third of all equities portfolios in passive or enhanced passive mandates.
Complexity in investments is not necessarily doomed to fail, Rogers says, but became mainstream in the last bull market, in which packed portfolios signalled “a trend to show that you were a good risk-taker”. “The whole financial industry wanted to do more interesting things in the past decade. A lot of that complexity turned out to be costly and people are looking to unwind that.” Taking a structural view of the industry, Gray argues that the number of active managers in business contributes to an overpopulation of participants in financial markets that ultimately provides a disservice to end investors and society.
Competition for short-term performance – among managers, super funds and their advisers – is eventually counter-productive as it arbitrages away opportunities at great cumulative cost, while pushing asset prices up, resulting in “huge transfers of wealth” among competing funds, to the benefit or detriment of often unwary members. The solution? Consolidating the market, so that only six funds and six active Australian equities managers exist, is one scenario being explored by Gray and Bird. “There are so many agents in the way – I’m an agent – that bring their own interests into it,” Gray says. “Consultants don’t always recommend indexing to anyone.
They should. Because there are more important things than picking managers, like asset allocation.” He says there is a need for more advice about asset allocation and investment strategies, in addition to manager research, but that consultants don’t get paid enough to make such a service worthwhile – “which is partly the funds’ fault”. “Another answer is for the funds to own managers but to hold them at arm’s length. Industry Funds Management is an example of that.” Once funds decide upon the markets in which they aim to concentrate their active risk, they need a consultant whose business model can support its needs, Rogers says.
If a fund is taking a more global view of alpha opportunities, for example, it requires a global consultant in order to plug into global research. “In Australia, you have local consultants that travel, and those that have relationships offshore, and global consultants. Bigger funds need global views. If you were doing a global equities search and compared the work of an Australian consultant and that of a global consultant, you would end up with different results.”
The ideal role of active management in super fund portfolios is to take decisive bets away from the benchmark, leaving risk management to indexers and asset allocators. But neither mode of investment management will win the active versus passive war because of their competitive interests, the appeal and elusiveness of true alpha, and the need for both in an efficient portfolio. “Will we always have everything active? Sometimes there might be fewer opportunities and a role for passive management,” says Hartley at Sunsuper. “If we were to get very, very big, it would make it hard to get value out of portfolios with only active managers.”
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