Is the Environment for Active Management Improving?

Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.

We are asked this question on a regular basis, but believe it is fundamentally the wrong question for investors to ask if they are seeking to outperform the market over the long term. Regularly, financial news headlines cite stock market correlations or dispersion levels as a driver of active manager success. Over the last 12–18 months, correlations have come down from peak or near-peak levels of this cycle, while dispersion remains low, although slightly improved. These dynamics have raised excitement that more active managers will be able to outperform the market. However, these measures show little-to-no statistical relationship to the ability of managers to outperform their benchmarks.

What does matter? Over shorter time periods, there are three simple factors that tend to explain active manager success or challenges reasonably well. More importantly, over the long term, manager skill followed closely by factors related to the ability of managers to survive appear to be the most important determinants of success. Managers tend to have persistent biases relative to market cap–weighted indexes, such as holding more equal-weighted portfolios that include a smaller-capitalization bias, holding securities that are not included in benchmarks (e.g., US equity managers holding non-US stocks or global developed markets equity managers holding emerging markets stocks), and holding some cash. Therefore, when smaller-cap stocks outperform large-caps, when commonly held out-of-benchmark markets and sectors outperform managers’ primary market, and when managers’ primary market underperforms cash, a larger portion of managers tend to outperform their benchmarks. Of course, the backdrop for active managers depends on the markets they are fishing in. For example, significant outperformance by emerging markets has been a great boost to developed managers on average over the last year or so.

Read the first quarter edition of VantagePoint for more detail on this analysis.

Over the long term, the factors described above matter very little for success. A more significant determinant of long-term success is mere survival. Based on our study of active US equity managers from 1996 to 2016, among the 1,368 US equity managers in our database at the start of 1996, a striking 73% are no longer reporting returns to our database. However, of the 27% (370 managers) that survived for 20 years, 85% (317) outperformed the relevant style index.

These 317 winners did not outperform over every short-term period. The majority of US equity managers that have outperformed their relevant style indexes over the full 20-year period have underperformed by a considerable margin from time to time. In fact, 60% experienced at least one three-year period in which they underperformed in each consecutive calendar year, and more than 90% underperformed in two consecutive calendar years. The underperformance was often severe. On an annualized basis, 18% underperformed by 10 percentage points (ppts) or worse over three years and by more than 5 ppts per year over five years. Only one manager suffered no bouts of underperformance over a three-year period.

Manager skill and the ability to survive into the long term appear to be the most important determinants of long-term winners—far more important than short-term performance. Indeed, the distribution of survivors and non-survivors in terms of percentage of years they outperformed their style index is quite similar. Organizational factors such as good governance, alignment of principal and agent issues, firm culture, and a loyal investor base are among the factors that influence success.

Investors should seek to understand managers’ performance history to appropriately set expectations for conditions under which managers will outperform and underperform, as well as the nature of performance under different environments. However, using even intermediate-term performance as a hiring and firing tool is misguided. Consider that the dollar-weighted returns of institutional shares of mutual funds are much lower—nearly 200 basis points—than the time-weighted returns that the funds report. This is because investors, even institutional ones, tend to sell managers when they are at or near their lows and buy in after a run of good performance. Active managers can be additive to portfolios, but it is difficult to do. If you cannot resist the temptation to fire good managers when they are down, it is probably best not to try as you are likely to underperform the market. Asking if this is a good time for active management is simply the wrong question for achieving long-term success.

Celia Dallas is Chief Investment Strategist at Cambridge Associates. Kevin Ely is a Managing Director on Cambridge Associates’ Global Investment Research Team. 

Originally published on January 30, 2018