On August 4th, the Globe and Mail reported that just 17% of large-capitalization equity fund managers in Canada outperformed their benchmark in the second quarter, which proved to be the worst quarter for active managers in at least 17 years. Similarly, the second quarter was the worst one for U.S. stock pickers in at least thirteen years, according to Merrill Lynch data which showed that a mere 18% of U.S. active managers outperformed their benchmarks during the quarter. Not surprisingly, the hue and cry for passive investments has never been louder, with a new ETF launched seemingly every other day, and with robo-advisers, albeit most of them still in in their infancy, attracting increasing investor attention. The active management world, for the most part, are taking these body blows in grudging silence, knowing full well that most active managers empirically do not keep pace with a passive index over time. We’d like to address some of the reasons why most do not, and why we believe we are different.
First, let’s understand what active management is, and what it is not. A popular misconception is that rapid and frequent trading activity is a necessary feature of an actively managed portfolio. While it might be the case that an active manager trades often, it need not necessarily be so. Frequent trading of an undifferentiated portfolio is the investment management equivalent of the employee who sits at his desk shuffling stacks of paper all day…it gives the illusion of “being busy”, but in itself creates no value whatsoever. In fact, in the investment world, it’s even worse than that, because unlike with shuffling papers, trading incurs real costs – both explicit commissions as well as market impact costs. Thus, a much more useful working definition of active management ought to make reference to managing a differentiated portfolio. That is, the portfolio’s composition ought not to simply replicate an index because an investor paying active management fees should expect the professional portfolio managers they hire to have strong (and hopefully well-informed) views about securities they like and those they do not like, and should expect them to own those that they like and to shun those which they don’t like. Sounds pretty intuitive, right? But remarkably, in practice, this is not what the majority of supposedly active funds actually do. The concept of “active share”, which was popularized in a 2006 white paper by Martijn Cremers and Antti Petajisto, called “How Active is Your Fund Manager” is very illustrative here. Active share essentially measures the percentage of holdings in a portfolio that differ from the benchmark index. A portfolio with an active share of zero is identical to its benchmark, whereas a portfolio with an active share of 100% holds no securities in common with its benchmark. Generally, portfolios with active shares above 80% are considered very actively managed, whereas those with active shares of 20-60% are referred to as “closet indexers” and those between 0-20% are either explicit or de facto index funds. In a related study published in 2011 called “Indexing and Active Fund Mangement: International Evidence”, authors Martijn Cremers, Miguel Ferreira, Pedro Matos and Laura Starks found that 37% of all mutual fund assets in Canada are held in funds that are closet indexers.
A couple of observations here: first, having high active share is no guarantee of outperformance. Having at least some degree of active share is obviously a necessary condition for outperformance though, and the first study cited above did find a strong positive linkage between high active shares and outperformance. The necessary and sufficient conditions for long term outperformance seem to be a combination of a differentiated portfolio coupled with skill in security selection. What is unambiguously clear though is the certainty of underperformance that a relatively undifferentiated portfolio burdened with a full (and sometimes rather high) active management fee imposes upon an investor. Which brings us to the ugly truth about why the active management world, broadly speaking, is taking these daily body blows from the press and from the up and coming passive investment community in silence: because they know their position is indefensible – their portfolios are undifferentiated, and yet their fees are “full” and reflective of truly active management. We will not stand silent though, because for reference, the Goodreid Canadian Equity portfolio has an active share of 73% and the Goodreid U.S. Equity portfolio has an active share of 86%. Moreover, despite the higher than average active share, the fees charged by this firm are roughly half those charged by the largest mutual funds in the country, many of whom have been shown by the second study to, in fact, be closet indexers.
Active management is not dead, and indeed may be on the cusp of a bona fide renaissance. Why? Because with passive funds increasing their market share, fewer and fewer dollars are being entrusted to professional and truly active managers, whose job it is to sniff out mispricings in the market and to capitalize on these mispricings for their clients. Finding “alpha”, or mispriced stocks is serious and difficult work…it’s not like catching Pokeman where just about anyone can stumble around and find it on every street corner. So, with fewer and fewer trained eyeballs searching for such opportunities and trading to capitalize upon them, more mispricings are likely to occur and to prevail for longer periods of time as price discovery is delayed. This is creating a more and more target rich environment for those of us who are truly active managers, and who have honed an effective and disciplined methodology for finding undervalued securities. The effort and discipline that goes into finding these undervalued securities has served our clients very well over time and we are increasingly confident that it will continue to do so.