In my last column, I suggested that the stock picker’s lot in life is not as bad as it’s made out to be.
I argued that many of the portfolio managers competing in this zero sum game (for every winner, there’s a loser) are destined to underperform for structural reasons, which leaves more of the spoils available for the truly active players.
Today, I’m going to focus on identifying the managers who are genuinely trying to win and provide a framework for determining which ones are best positioned.
Truly, madly, active
“… it is better for the reputation to fail conventionally than to succeed unconventionally.”
John Maynard Keynes’s famous quote reminds us just how strong the pull is toward the warmth of the herd. But by definition, active managers are non-conformists and build portfolios that look and behave differently compared to the index. They can be identified by looking at their holdings and performance histories, which will differ from the herd, but there’s also a statistical measure that’s increasingly being used.
“Active Share” is a concept developed by a pair of former Yale professors, Martijn Cremers and Antti Petajisto. It measures how much a fund differs in composition from its benchmark. A fund is considered to be “moderately active” when 60 to 80 per cent of its holdings are different, and “truly active” when the score is more than 80 per cent. The professors categorize funds under 60 per cent as “closet indexers.”
There’s a good news/bad news story here. The professors’ research shows that the higher the Active Share, the higher the returns. Unfortunately, their work also shows that 70 per cent of Canadian equity funds don’t qualify as being actively managed.
With a better reading of who the active managers are, the next step is to cull the list further by assessing their skill, fees and structure.
Skilled investment managers have an edge. Their decision-making process, and every aspect of their firm, is characterized by rigour, discipline and repetition. Most importantly, they’ve produced a good long-term record in terms of returns and/or downside protection.
Fees are the most certain part of a manager assessment. They’re a hurdle that has to be overcome every year. Low-fee strategies don’t need as much skill or structural advantage as those that charge a 2 per cent base fee plus a 20 per cent performance bonus.
I’d like to drill more into the part of the assessment that’s often overlooked – the structure around the manager. Where a portfolio manager sits plays a huge role in how sustainable his/her performance is. They need a supportive organization that’s focused more on long-term returns than short-term sales targets. To be able to run against the herd, they need a culture where senior management and the client service team are covering their back. There’s no doubt, underperforming “unconventionally,” to borrow from Keynes, puts more pressure on everyone.
A good structure has clear lines of responsibility. Managers must be able to make decisions quickly and without the dilution that comes from too much group-think. In this regard, clients need to know who’s involved in the portfolio (who’s losing sleep) when things aren’t going well. When accountability is spread across a large team or committee, there’s a risk the only ones sleeping poorly are the clients.
Managers need the freedom to apply their skill. It’s hard to win if their hands are tied behind their back. This means not having too many style or portfolio constraints, which allows them to pursue undervalued securities wherever they find them. Hedge funds score well in this regard, as they’re able to range far and wide, short sell securities they don’t like and use leverage.
It’s also important to be “right-sized,” which varies across asset classes. Generally, smaller managers can pursue a broader range of opportunities, but larger, better-resourced firms have the advantage in some categories.
And of course, truly active managers need clients who expect their returns will be significantly different than the index, sometimes for extended periods. Lots of good different, but plenty of bad different, too.
There are no guarantees with active management, but the odds of winning the game go up if you find a manager who is genuinely trying to win and has a good combination of skill, fees and structure.