Twenty years is a long time in the investment world. As K.J. Martijn Cremers, Jon Fulkerson and Timothy Riley note in their most recent study, “Challenging the Conventional Wisdom on Active Management.”
The professors wanted to revisit the conventional wisdom on active managers, specifically that: 1) average funds underperformed after fees, 2) the performance of the best funds do not persist, and 3) some fund managers are skilled, but few have skill in excess of costs.
They note that a landmark study by Mark Carhart in 1997 did “not support the existence of skilled or informed mutual fund portfolio managers.” That study was released when only 8% of the assets in equity funds were passively managed; today it’s 40%. In addition, the fee paid to actives funds has decreased by about 20% in that time.
(Related: Are Index Funds Communist?)
Upon reviewing the past 20 years of research, Cremers, professor of finance at University of Notre Dame, noted that “current academic literature on mutual funds also finds a substantial body of research that disagrees with [the above] conventional wisdom.”
To that point, he cited a 2015 study by Jonathan Berk and Jules van Binsbergen that found the average active fund outperforms an equivalent index fund by 36 basis points per year. He also said a study he did in 2009 found that funds with “high active shares, meaning funds with holdings that greatly differ from their benchmark, tend to outperform their benchmark.”
Cremers and his co-authors concluded that in reviewing the past 20 years of academic literature, the conventional wisdom is wrong, and that studies have shown that “active managers have a variety of skills and tend to make value-added decisions, such that, after accounting for all costs, many actively managed funds appear to generate positive value for investors.”
While Cremers presented these findings during a live-streamed event presentation, “Advantages of Active Management in a Powerful Portfolio,” sponsored by the Active Managers Council, other speakers also showed compelling evidence of the advantage of active managers.
In his presentation, David Lafferty, chief market strategist of Natixis Advisors, discussed myths regarding active managers. “It’s important to understand there are systematic differences between universes of active managers and the indexes that they [compare against],” he said. “These differences largely explain the fortune or misfortune of many of these active managers from period to period.”
Key factors Natixis looked at for this differential include market direction, in which Lafferty noted, the “vast majority of actively managed portfolios hold cash; market cap indexes do not.”
He also pointed out that “all things being equal, bear markets should help active managers.”
Lafferty said that smaller-cap stocks are better for active managers because “large-caps eat up a portfolio.” Further, ”benchmark density is important,” that is the S&P 500 is “fairly dense, it has lots of names with big weights.” However, the Russell 2000 typically has stocks with low weights and is less dense. Therefore, he says, it should be easier for active managers to beat it as a benchmark, largely due to active share.
Another myth, he said, was that indexes are killing active management. In what he calls “Portfolio Darwinism,” he says the competitive pressures of passive indexes actually is making active management more competitive — and better.
He also notes that fee compression is happening for active managers, “but not by much” — about 4 to 5 basis points in the past 10 years. However, asset-weighted fees have come down “dramatically.”
Lafferty stated that “indexing will not kill active managers, but it will kill bad active management: those who charge too much, don’t have enough active shares, and turn their portfolio over too much.”
Presenting an asset manager view was Scott Gonsoulin, investment manager of the $150 billion Teachers Retirement System of Texas, which has 80% of it assets with active managers.
“We believe active management works, but it works better in some places than others,” Gonsoulin said. He showed how U.S. large-cap managers underperformed their benchmark by 35 basis points over the past three years, while international managers were up by about 100 basis points.
This differential has been consistent since the financial crisis of 2008, he said. “In fact, pick a random [Europe, Australia and the Middle East] manager, and you have about a 75% chances of outperforming the benchmark.”
He said they also believe that “risk factors generate excess returns and our portfolios should be positively exposed to them, for example, value, momentum and quality, also known as defensive,” and added that their internal quant team manages the smart beta strategies.
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