Investors are increasingly looking to make their portfolios more efficient. As such, the age old question about adopting an active or passive management approach comes up again and again. Mercer has recently released its latest guiding principles on active and passive management, which consider the asset classes that offer the best opportunities for active management on a forward looking basis.
Let’s be clear: neither active nor passive management approaches will always be the right strategy for all investors. The chosen approach needs to be consistent with the investor’s own set of investment beliefs.
For some investors, a passive “autopilot” portfolio, mirroring the relevant indices, is simpler and more cost effective than trying to identify the best active managers. But many investors hope to beat the index and seek out skilled active managers to do so. A successful implementation approach for active management is three-pronged: first, identify those asset classes where active management has the greatest opportunity to deliver outperformance; second, identify the best active investment managers; and third, negotiate a competitive fee structure that is expected to deliver above-index returns on an after-fees basis.
Mercer’s Hendrie Koster, Director of Strategic Research for the Pacific region, emphasises that there is no single correct answer to the question of which manager is right for which investor. Instead, Mercer uses guiding principles to undertake a qualitative overview of which asset classes offer the best active management opportunities, followed by a comprehensive assessment of more than 20,000 investment manager strategies globally.
“Where investors have a belief and conviction that active management can add value over the long term, they need to target those asset classes and opportunities that are most compelling,” says Koster. “A couple of key question to consider are: Can you achieve the desired outcome at reasonable fees and do you have an appropriately long investment time horizon to tolerate the ebbs and flows in performance that come with an active management approach?”
Finding the right active manager
While there are many ways to manage money successfully, Mercer’s research shows that the best managers typically have characteristics and approaches to the ways in which they operate that set them apart from the herd. As with any profession, some investment managers are more skilful than others, and can consistently uncover and exploit opportunities created by the market’s mispricing of assets.
“A key factor is the quality of the people who make the investment decisions, using a skilled, robust and repeatable approach,” Koster says. “League tables have no understanding of whether the investment manager was just lucky or exhibited skill. What we look for is a well-articulated investment process that, together with a skilful investment team, is expected to deliver outperfomance on a systematic and consistent basis.”
For example, a top-notch emerging market equities manager will typically have dedicated analysts based in the relevant countries with their ears to the ground. Similarly, the best corporate bond market managers will produce top-quality research to identify issuers that may be at risk of downgrade or default.
Other attributes that Mercer looks for include superior insights and understanding of behavioural factors, a willingness to take a longer-term view and an ability to “join the dots”.
Choosing the right asset classes and markets
Highly skilled active managers are able to quickly seize on alpha opportunities created from inefficient pricing of assets. Typically, inefficient markets are less developed, with slower information dissemination and less institutional investors and analysts.
As Koster puts it: “The more inefficient a market is, the better the potential for outperformance with active management.” An important part of an active management strategy, therefore, is to recognise which markets offer sufficient raw market potential for alpha generation.
A key consideration is market breadth with a wide pool of diverse investment opportunities and sufficient liquidity. The quality and flow of price-sensitive information and the number of sophisticated investors participating in a market is also important in assessing opportunities for active managers to gather better information than others.
From a qualitative perspective, the best equities opportunities for active management outperformance are in small caps and global emerging markets. In fixed income, Mercer’s research shows that the highest raw potential is in emerging market debt and high yield markets. Given their relative efficiency, the lowest raw market potential for active management outperformance is in US large cap equities and government bond markets.
Evidence of outperformance
This may all be good and well in theory, but what about the actual delivery of outperformance? Mercer’s analysis of historical returns across various asset classes shows some surprising results, especially net of fees. Using Mercer’s extensive investment manager database, we compared the actual returns achieved by the median investment managers against the relevant indices over different time periods to 31 December 2015, then deducted the median fees.
The median Australian equity active manager has outperformed on both a gross and net of fees basis. Over both five and ten year measurement periods, the median manager generated in excess of 1%pa outperformance against the relevant index, net of fees. In Australian small cap equities, the median manager outperformance was very strong: 10%pa outperformance over five years and 7.3%pa outperformance over ten years.
In contrast, the median emerging market equities manager outperformed the index over ten years, gross of fees; but the high fees typically associated with this sector eroded most of the alpha gained.
In Australian fixed income, the median manager’s net of fee performance was largely flat over the various time periods evaluated.
Over time, these results are expected to shift as we go through different phases of the market cycle. For example, the alpha deliver by active managers has generally been more sedated since the Global Financial Crisis, largely explained by the bull market supporting growth across asset classes and sectors. However, skilful asset managers are expected to show their worth as markets ‘normalise’ and the inevitable market corrections occur.
“Our research shows that the historical results can be very time sensitive and depend on when the analysis is carried out. In addition, while some asset classes look attractive on a qualitative basis, the historical results on an after fee basis are not that convincing,” Koster says. “On balance, the preference may still be for active management, but investors must have strong conviction in identifying and hiring superior active managers and they must be able to negotiate competitive fees.”