Setting the Record Straight on Active Management | 5 Key Takeaways
January 30, 2020
“Active managers can and do outperform,” asserts Dave Lafferty, Senior Vice President and Chief Market Strategist at Natixis Investment Management and Chair of the Active Managers Council. But that outperformance varies “across time, categories, and market environments.”
In other words, the conversation about active management is complicated and nuanced – and not fairly captured by the oversimplified memes of scorecards, hit rates and zero sum games.
Lafferty discussed the need for a more balanced narrative on active management in his presentation during a January 2020 webinar for independent fund directors sponsored by the Mutual Fund Directors Forum. The webinar was moderated by Karen Barr of the Investment Adviser Association and also featured presentations by Carol Geremia of MFS Investment Management and Darby Nielson of Fidelity Investments.
Lafferty’s presentation provided an overview of his recent white paper, “A More Balanced Narrative: Setting the Record Straight on Active Management,” which was published by the Investment Adviser Association’s Active Managers Council in November 2019. Key takeaways from his remarks are:
Don’t read too much into the scorecards.
Both S&P and Morningstar publish biannual reports that attempt to provide a summary assessment of active management’s performance compared to passive alternatives.
While these reports are “insightful,” suggests Lafferty, they are “hardly definitive.” Because of differing assumptions, they can reach wildly different conclusions. He cites the example of U.S. high yield bond funds. According to the S&P’s SPIVA report, only 4% of these funds outperformed their benchmark for the 10 years ending June 2019, while the Morningstar Active/Passive Barometer calculated that 57% outperformed over the same period.
Sharpe’s zero-sum theory isn’t a proof.
In a 1991 paper titled “The Arithmetic of Active Management,” William F. Sharpe argued that, because all active managers – in aggregate – earn the market return, after deducting expense, the average active manager is doomed to underperform.
While Sharpe’s argument is a compelling theory – and one that has gotten a lot of attention – Lafferty contends that it doesn’t prove that the average mutual fund manager will necessarily underperform, at least in the way measured by the scorecards.
That’s because of the “skew” of assets across managers and “slippage” to non-mutual fund investors – neither of which are reflected in the scorecards’ methodologies. (See the white paper for tables that illustrate these concepts.)
It’s a cycle, not a lack of skill.
In fact, active managers do outperform, though that outperformance varies across time, asset classes and market environments. For example, the last 10 years have been difficult for active managers investing in U.S. large caps, though in the preceding decade, U.S. large cap managers dramatically outperformed.
Systematic differences in the average active portfolio when compared to the benchmark “go a long way to explaining why active managers do well in some periods but not others,” suggests Lafferty. For example, active managers often have higher exposure to cash, smaller cap stocks and credit risk. (Again, see the paper for charts illustrating the effect of these exposures.)
It’s not a question of market efficiency or skill, he argues. “It’s highly unlikely that markets were radically efficient in one period – making it difficult to outperform – and all of sudden completely inefficient in the next period when active managers dramatically outperformed.” Similarly, it can’t be the case that “active managers were brilliant in one quarter and then all of those same active managers became foolish in another quarter.”
The search for persistence is fundamentally flawed.
In a double whammy, this variability in performance has been presented as a drawback of active management by detractors, who suggest that active managers fail if they don’t outperform in every period.
“Of course, consistency is great,” counters Lafferty, “[Everyone] would prefer to outperform in every period, but it shouldn’t get in the way of making money over the long term.”
“Most active managers concede that periods of short-term underperformance are necessary to generate excess returns in the long run,” he adds. As a result, managers with the strongest long-term results generally have periods of underperformance along the way.
Active management keeps getting better.
At the same time, a focus on active management’s past performance is misplaced.
Active managers are evolving rapidly. They’re reducing costs to investors, by taking advantage of portfolio management and operational advances to generate efficiencies. They’re focusing on generating alpha, often by increasing benchmark differentiation and lengthening time horizons. And they’re putting an even greater focus on risk management, to ensure that they’re meeting investor goals.
Overall, Lafferty concludes, “The future of active management is bright.”
Mutual Fund Directors Forum members can listen to a complete recording of the webinar on the Forum’s website at mfdf.org.
Active Managers Council members can also listen to a complete recording of the webinar in the members-only section of the Council’s website at activemanagers.com.