How should active management fit into one’s portfolio?

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The trend in the great investment debate over active versus passive management is clear, but that does not mean that the issue is simple or even almost settled.

While index funds have been the clear winners over the past few years, both in terms of performance and investor preference, analysts say the current economic environment is one where simply following the market may not deliver. the best return or the best protection against risk. And in equities, where gains are expected to continue for years to come, but less generally, having the right manager can protect against volatility by adjusting to changing conditions.

“We believe that the active / passive debate does not provide a clear winner. In our view, the two strategies can be used together to help maximize expense reduction without completely eliminating the investment opportunities offered by active managers, ”analysts from the Wells Fargo Investment Institute wrote in a recent report.

“We believe that the active / passive debate does not provide a clear winner. In our opinion, the two strategies can be used together to help maximize expense reduction without completely eliminating the investment opportunities offered by active managers.


– Wells Fargo Investment Institute

Passive funds simply follow a benchmark like the S&P 500 SPX,
-1.28%,
while active funds have their portfolio components chosen by an individual or a team. In recent years, the movement has resolutely turned to the passive. According to Morningstar, active funds posted outflows of $ 285.2 billion last year; passive funds attracted inflows of $ 428.7 billion. (Despite this, more assets continue to be held in active than passive strategies: $ 9.3 trillion compared to $ 5.3 trillion at the end of 2016.)

Investors have adopted them for a variety of reasons. Index funds aren’t just cheaper than actively managed ones: passive US equity ETFs have an average expense ratio of 0.344%, according to Morningstar, although the most popular have fees below 0.1%; the average of active funds is 0.864%, but they offer better performance. According to the S&P Dow Jones indices, the number of active funds that have outperformed over the long term is practically zero.

See also:In equities, almost all types of active managers got worse in their jobs in 2016

These statistics are however distorted by the fact that Wall Street has been in a particularly favorable environment for passive management. Bull markets, whose current celebrated its eighth anniversary earlier this month, favor passive strategies through “rising tide” environments. Since market gains have been prevalent for years, with virtually all sectors participating, it has been extremely difficult for active managers to outperform this performance, especially over long periods of time, and especially taking into account their overheads. students.

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“Active managers may outperform their passive peers in the latter part of a recovery, where we believe that recovery can be.”


– Wells Fargo Investment Institute

Lately, however, the correlations between individual stocks have been declining, giving stock pickers a chance to find undervalued stocks and avoid overvalued stocks, creating a better chance of outperforming.

“Active managers can outperform their passive peers in the latter part of a recovery, where we think that recovery can be,” Wells Fargo wrote.

The data supports the idea that the broader active outperformance is cyclical, as shown in the following chart, which was provided by Altus Securities and uses data from the Center for Research in Security Prices.

This graph, however, hits one of the hurdles faced by active management. The long-term average has around 40% of active managers outperforming, overall. This means that investors always have a better chance of sticking to the benchmark, especially since they cannot invest in an “active” category — they must select a specific fund.

Choose an active manager

With thousands to choose from and each offering their own investment strategy or philosophy, finding the rare actively managed fund that would outperform net of fees over the long term is a daunting task, and one that investors typically choose against.

Read on:Wall Street pushes active management, but investors don’t bite

See also:New actively managed ETF struggles to find contrarian bets among unfairly shorted stocks

Nonetheless, if the market does indeed enter an environment where the right manager can preserve capital or increase returns, this is a task investors should consider.

The first step, analysts said, was to view active management as an addition to one’s portfolio, not a replacement for index funds which are widely regarded as the best core holdings for any investor. In a market that favors value, for example, a manager with a growth orientation can offer the same diversification benefits as exposure to bonds.

Second, analyze funds as potential long-term holdings, not temporary positions to overcome periods of volatility or weakness. And finally, look for sub-categories of the market where a manager’s professional analysis can add value, analysts said.

“Your probabilities of success with an active manager are better in high yield bonds than in government bonds, in emerging markets rather than developed and in small cap stocks rather than large caps,” said Steve. Lipper, senior investment strategist at Royce & Associates LP, an active management firm that focuses on small businesses. “Because there are more small companies and less analyst coverage, managers can more easily find value there than they could in the large-cap space.”

Within these categories, Lipper said, there are a variety of metrics that can help assess the quality of a fund and its manager. In addition to the fund’s expenses and past performance, measured against their benchmark over a variety of market conditions and economic cycles, potential investors should check how long the manager has supervised the fund, if they invest their own money and degree of “active share” in it.

Active share is a measure of the overlap between a fund and the benchmark it tracks (for example, a large cap fund and the S&P 500). The higher the active share, the less correlation it would have with the benchmark, which gives it more value as a diversification tool and creates the potential for outperformance (although this also increases the chances of underperformance). performance).

Learn more about active sharing:This figure helps explain why so many active ETF managers are underperforming

Lipper recommended funds with an active share of at least 80%, the same figure cited by analysts at Morgan Stanley Investment Management.

“If you want an active manager, then you want an * active * manager,” Lipper stressed. “You want it because it doesn’t look like the benchmark.”

He highlighted the Royce Pennsylvania Mutual Fund PENNX,
-1.39%,
one of his company’s flagship offers. The fund, which has $ 2.4 billion in assets, has an active share of 88%, according to its website, and fund manager Chuck Royce, who was not available for comment, operates it. since 1972. In a market scarcity, Royce’s tenure actually exceeds the lifetime of the Russell 2000 RUT,
-0.97%,
the benchmark that his fund now tracks, which was introduced in the late 1970s.

A table comparing the annualized performance of the Royce Pennsylvania Mutual Fund versus the Russell 2000. Note how the fund’s outperformance becomes larger over a longer time horizon.

Royce Funds also requires its top portfolio managers to have at least $ 1 million of their own money in the funds they oversee. Data has shown this to be a good indicator of future performance, as these funds outperform those where managers do not invest their own money.

According to a Morningstar report from September 2016, a group of funds where managers don’t co-invest had “a meager 35% success rate” over a five-year period. “Those with between $ 100,000 and $ 500,000 [invested] had a 43% success rate, and those with more than $ 1 million had a 47% success rate, ”wrote Russel Kinnel, director of research for the company’s managers. “Because about a third of the funds were merged or wound up in that five-year period, a 47% success rate is actually pretty good.”

Even with these parameters, however, passive funds are almost universally regarded as the best choices for making up the bulk of an investor’s portfolio, even from the perspective of active managers themselves.

“If you want passive exposure, vanilla funds are the way to go. But if you want something that isn’t correlated to the market, or that relies on an alternative data set, active managers are looking for higher returns, ”said Petra Bakosova, COO at Hull Tactical Asset Allocation. , and a portfolio manager of the Hull Tactical US ETF HTUS,
-0.73%.

To verify:Why Advisors Say Tactical Allocation Funds Usually Aren’t Worth the Fee


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