August 10, 2020

Monday Morning Memo: Active Managers Need Tactical Change to Win Active/Passive Debate

by Detlef Glow.

Active fund managers are permanently under scrutiny in the ongoing debate about the value added by active management compared to passive products such ETFs and index funds. The debate is often driven by a view on management fees, with critics arguing that actively managed funds are too expensive and do not in most cases deliver any value added for their investors.

This argument is correct if one only looks at performance tables measuring the relative performance of an actively managed fund versus its benchmark since only a minority of active managers are able to achieve an outperformance relative to their benchmarks. Therefore, a passive investment product seems to be the better choice since it has lower fees and delivers on average higher returns.

Even worse, while active managers foster investor expectations that they can beat their benchmarks, ETFs are expected to underperform their benchmarks by the amount of their management fees. Some of them, however, are delivering an outperformance by engaging in securities lending. That said, a number of active funds also use securities lending to generate additional income for the portfolio, but still underperform their benchmark.

As a market observer and analyst, I want to understand the reasons behind the fact that such a high number of actively managed funds are not able to beat their benchmarks since not all of them can be bad managers. First of all, one needs to bear in mind that some of the performance analysis provided to the market is biased. For example, many analysts use a generic set of benchmarks which might not be aligned with fund managers’ benchmarks. But even if the comparison is done with the correct benchmarks, the results do not get much better.

From my point of view, this means that the underperformance as well as the outperformance might be caused by the management process, and I see the current risk management practices as a main reason for the possible underperformance of a fund. While real active managers are aware of the allocations in their benchmarks, they do not always hew tightly to them and can over and/or underweight single securities, sectors, countries, or regions according to their market views. Conversely, a number of asset managers run their risk management on a relative basis. For example, they measure the risk within the fund relative to the benchmark and not with regard to absolute losses. This approach assures that the performance of the fund is somewhat in line with the performance of the benchmark to avoid any kind of reputational risk caused by investments that are not aligned with the benchmark and investor expectations.

While this approach sounds reasonable it is a hindrance for the fund managers when it comes to achieving an outperformance of their benchmark. This is because this approach means that they may be able to underweight a single security by 10% compared to its benchmark weight, but this does also mean that the fund manager has to own the respective security even if they have a very negative view of it. In some cases, the portfolio managers are allowed to cut a security out of their portfolio but have to maintain the sector and/or country/region weightings of the benchmark. This gives the portfolio manager a bit more freedom to implement their investment views, but still restricts them heavily. Especially as the above is also true for overweighting single securities and/or sectors.

That said, I would assume that a high number of active asset managers need to rethink their risk management processes if they want to win the performance argument against their passive peers. In addition to this, a sustainable outperformance will also end the discussion around the level of fees charged by active managers. To achieve this, active managers must become more honest with themselves, as I have often witnessed that the performance of a fund is presented “gross of fees” since these results look better than the “net of fees” returns. However, by deducting the ongoing charges or total expense ratio (TER) from the outperformance, one often sees that the fund is not adding any value for the investor. This is the case even when the fund manager might have achieved a sustainable outperformance of 150 basis points per annum compared to his benchmark. Therefore, a “gross of fees” analysis may make sense when it comes to the internal evaluation of a fund manager, as the manager is not responsible for fees and expenses, but it does not make any sense for customer or internal board reporting with regard to value added reports.

Since the board might also be responsible for the implied risk management processes, it is not surprising that the board members do think that there is no need for change in the processes. The funds they are responsible for do deliver value added and, therefore, are reasonably priced if one looks at “gross of fees” reports.

The views expressed are the views of the author and not necessarily those of Refinitiv. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.

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