Conventional wisdom suggests that markets with a wider spread in returns between the top and bottom performers (also called dispersion) can reward an active investment approach. These rewards can be boosted further in markets where new information is harder to come by and diligent research can add consistent value.
In equities, a good example of this might be Smaller Companies or Emerging Markets, where the gap between the best market and the worst can often be significant. For instance, in 2015, Hungary (a component of the Emerging Market Index) returned +52% (in local currency terms) and sharply outperformed Greece, which fell by 56%. In situations like these, having the skill to make the right active call can add substantial value.
Does recent volatility favour active management?
Given the recent volatility in equity markets since the start of the year, it might be reasonable to expect that this has caused a period of wider dispersion in returns, creating an environment that has become more favourable for active managers. While this may indeed be the case, it is more important to consider an investment strategy that meets objectives through the market cycle: active management is a long-term solution.
Morningstar data shows that, on an after fees basis, a significant proportion of active managers have outperformed their benchmarks over the long-term (5 years or more). And remember that even modest outperformance on a per annum basis can add up to significant gains over the investment period. It’s true that an active manager may underperform a given benchmark over a shorter period (and it’s a given that even the top-performing active managers will underperform at some point), but the positive long-term track record remains a compelling attraction for investors.
The starting belief for active management is that markets are not efficient, which can create opportunities and a sustainable advantage for well-informed and disciplined active participants over the long-term. Certainly, how active managers position themselves to exploit those market inefficiencies can vary widely. For some it may be their guiding philosophy that influences the investment process, for others it may be about identifying valuation discrepancies at a more fundamental level. The common aspect, however, is a level of conviction that allows the active manager to take a position that varies, sometimes materially, from a given benchmark.
What drives conviction?
Two key ingredients to fuel conviction are research and experience. Research is the base on which an active manager can build their conviction and is often the cornerstone for delivering a repeatable process that can beat the benchmark over the long-term. It is also often the basis for that mark of specialization that is an active manager’s point of difference. When combined with a level of experience that can look through detrimental behavioural biases and that often covers multiple market cycles, the active manager is in a position to act on their conviction.
Conviction in active management is typically displayed in two ways: through active share and in the length of time that a positon is held for. Active share is the sum of how far individual positions differ from an underlying benchmark. A low active share shows that the manager is only diverging from the benchmark to a small degree – at its extreme, no active share would indicate that a fund is exactly matching the benchmark. Studies show that those managers with a higher active share and a longer holding period have tended to outperform by the highest margin over the long-term.
Managing Risk
Another important component of active management, which can be overlooked in the pursuit of short-term performance, is that of active risk management. This is normally measured against the underlying benchmark’s passive outcome.
One of the key challenges with a benchmark is that it reflects past winners, whereas an active manager positions their portfolio to capture expectations for the future. Also, an active approach can modify its composition during times of market stress, to mitigate the extent of any fall that an underlying benchmark may be exposed to. A strategy that mirrors a benchmark closely may benefit in a strong market, but will have to consider a more radical approach to avoid a drawdown if the environment sours (for instance exiting, or timing the market). An active approach can be better placed to manage these risks through different conditions while retaining exposure to the underlying market.
The right amount of diversification
Another key function within the risk management consideration is ensuring that there is sufficient diversification within the active portfolio, across individual holdings and possibly by sector and country. An important point, though, is that the active manager does not dilute their conviction through over-diversification – that the risk exposure, a key function of the active return, is deliberate.
Individual investors should, in the first instance, be guided by their own investment objectives, though a disciplined and proven active manager can make a difference by providing superior risk-adjusted excess returns over the longer term.
Important information: The content of this publication are the opinions of the writer and is intended as general information only which does not take into account the personal investment objectives, financial situation or needs of any person. It is dated 5th April 2016, is given in good faith and is derived from sources believed to be accurate as at this date, which may be subject to change. It should not be considered to be a comprehensive statement on any matter and should not be relied on as such. Neither Zurich Australia Limited ABN 92 000 010 195 AFSL 232510, nor Zurich Investment Management Limited ABN 56 063 278 400 AFSL 232511 of 5 Blue Street North Sydney NSW 2060, nor any of its related entities, employees or directors (Zurich) give any warranty of reliability or accuracy nor accept any responsibility arising in any way including by reason of negligence for errors and omissions. Zurich recommends investors seek advice from appropriately qualified financial advisers. Zurich and its related entities receive remuneration such as fees, charges and premiums for the financial products which they issue. Details of these payments can be found in the relevant fund Product Disclosure Statement. No part of this document may be reproduced without prior written permission from Zurich.
Past performance is not reliable indicator of future performance. GINN FVHHKJ.00012.ME.036. CSTT – 011230-2016
