With the striking increase in the number of low cost passive funds now available, whether your investments are actively or passively managed is becoming a bigger concern for investors these days. Research and publicity, not to mention returns, are all playing into the debate of which style is best. At the end of the day, your advisor will recommend a diversified portfolio of investments; however we will dive into a few of the myths and realities of active management here.
1. What is active management?
Before answering, it’s important to bear in mind the definition of passive management. Passive management is whereby the portfolio of a mutual or exchange traded fund mirrors an index. Stock selection in a passively managed fund is by virtue of its presence on an index, and the index does not discriminate between good companies and bad companies. So long as they have share volume and are liquid, they can be added to an index.
There are many types of active management, but one thing all active managers have in common is that they will undertake investment analysis of a company, over and above its presence on an index. At Pender, we focus on bottom-up fundamental active management, whereby deep due diligence on a company’s business prospects is performed. As such, we consider each investment from the perspective of a business owner in order to achieve our goal of superior risk-adjusted returns compared the index over the long term. This is in stark contrast to a trader, who looks to flip each investment quickly.
2. Why choose active management?
It boils down to reducing volatility, minimising losses and maximizing potential gains. There can be no hope of accomplishing any of these goals without active management. By definition, a passively managed portfolio will experience exactly the same movement as the index. No more, or less, than 100% of the volatility, losses and gains.
2.1 Downside protection
Investors in index funds have enjoyed a recent run of returns as markets have climbed, providing a real tailwind for passive managers.
Since the financial crisis, the indexes robust returns have led to more and more investors piling into passive funds. Once an investment into a passive fund is made, these funds must go out into the market and buy each index company, regardless of the company’s business prospects. Increased buying leads to increased prices which leads to even more buying – what could go wrong?
Well, the same phenomenon which leads to ever-increasing prices, leads to ever-decreasing prices. We have never before in the history of financial markets had so many assets held in passive funds. If one requires downside protection, or a reduction in volatility, this should be of major concern.
Passive funds offer little protection in a downturn and the underlying indexes that they track can be positively and negatively affected by the existence of these passive funds.1 Actively managed funds can offer outperformance during the boom years but more importantly they can offer downside protection during the bust years. The two charts below show the performance of $10,000 invested in the Pender Small Cap Opportunities Fund during an up market (May 2012 – July 2014) and down market (Aug 2014 – Feb 2016).
Passively managed funds cannot offer the same claim of downside protection as actively managed funds. A simple mathematical truth shows that downside protection is essential to long term capital appreciation. Imagine you have $10,000 that declines 25% to $7,500. It takes a subsequent 33% positive return to reclaim your lost capital. Because of this fact, it is our strong belief that downside protection must be a key focus of any investing strategy.
There are a number of ways in which a true active manager can protect capital. We are focused on these areas.
- Margin-of-safety: By targeting good quality, but undervalued stocks, active managers aim to buy at a discount which builds in a “margin of safety”. Buying at a discount means there is more protection as undervalued stocks have less far to fall than overvalued stocks.
- Cash: Active managers often keep cash in the portfolio for two reasons.
- Cash is like another asset type. If it’s not invested, its value can’t fall
- It is available to buy good companies at the lower prices created by the downturn, which increases the upside potential of the fund.
- Unpopularity: During a downturn the most popular stocks are sold off first. Unpopular stocks below a certain market cap or in market niches are less liquid. They tend to have fewer investors and are owned by insiders and knowledgeable investors, like active managers, who are not panic sellers and have a longer term time horizon. Valuations can be more robust and participation in the downturn may be limited, adding to portfolio protection.
2.2 Out Performance
The goal of investing is to generate returns which allow you to fulfill your ambitions, send your kids to college or retire financially secure. You need to make sure your money is growing and since you can’t actually predict future performance, you need to stack the odds in your favour. If you can identify pockets of consistent investment success then you can narrow the field. In the quest to outperform the market, active managers rely on a number of strengths over passive managers. These include:
- Active managers are generally unencumbered by restrictions, which can put the brakes on performance, such as investment weighting or company size.
- They can operate in uncorrelated, unfollowed parts of the market where there is less competition on price so they can buy $1 in value for 50¢.
- They are free to exercise their investing expertise within their “circle of competence”. Managers can use this expertise to take advantage of an analytical edge over others.
- They aren’t restricted to buying and holding, but can actively manage holdings. Investments can be bought and sold over time, and weightings in the portfolio are adjusted dependant on a company’s individual merits.
However, passive management devotees are quick to note that a large majority of “actively managed” funds do not outperform their benchmarks over time. This is a well-researched topic but once you look behind the numbers a different story starts to emerge.
It turns out that a practice called “closet indexing” has cast a shadow on active management and skewed the data. The word “active” has been used fairly loosely when it comes to portfolio management. A Yale professor, Antti Petajisto, wrote “Closet indexing is the practice of staying close to the benchmark index while claiming to be an active manager and usually also charging management fees similar to truly active manager.”2 Investors are becoming increasingly aware of this practice, especially given the associated higher fees. As a portfolio manager it is hard to outperform the index when you are the index, added to which you are charging more in fees as an “active manager” which eats into any upside you do achieve.
Two professors at the Yale School of Management put the theory of mutual fund underperformance to the test. Having identified true active managers using a measure they called Active Share (see below), they then analysed performance. Their research found that “fund performance in excess of the benchmark is significantly related to active management”3 and that of their sample of US equity funds, ones with the highest active management outperformed benchmarks by 1.51%-2.40% per year before fees.
3. How can you identify a true active manager?
Closet-indexing has muddied the waters. Added to which is the recent run in the markets which has masked all effort. Active or passive, returns have been positive either way. So how can you distinguish true active management?
Active share, as referenced above was developed by Martijn Cremers and Antti Petajisto and discussed in their paper3, is a relatively new calculation and provides a measurement of how actively a portfolio is being managed. An active share of 0% is a portfolio that precisely matches the index and can be considered to be passively managed. Whereas a portfolio with an active share of more than 60% can be considered to be actively managed as 60% or more of the portfolio is different than the index. A true active fund is one which is managed independently of the index. Any crossover with the index is the result of independent analysis.
This is a fairly new metric and is less frequently reported. It is our hope that this becomes more widely reported as regulatory scrutiny increases into the practice of closet indexing4.
4. Why is there a difference in fees?
With little effort required to “manage” a passive fund, fewer costs are accrued and investors pay very low fees.
There is a considerable amount of work when actively managing a portfolio using deep fundamental analysis. This analysis starts well before an investment is added to a portfolio and continues throughout the duration of the holding. Our fundamental analysis includes:
- Risk Analysis:
- Evaluating balance sheet and financial risk: conservative financial profiles are more likely to survive business cycles, mismanagement and other changes that inevitably impact most companies from time to time.
- Evaluating valuation risk: If an investor overpays for a stock, it does not matter how well the underlying business performs; the returns will likely be mediocre or worse.
- Evaluating business/earnings risk: The presence of competitive advantages like scale, patents and well‐loved brands help to reduce business risk.
- Management analysis: This includes historical and current analysis of management’s experience and the track record of their capital allocation decisions.
- Industry dynamics and competitive positions analysis: research into the potential investment candidate’s business model and position within its industry.
The increased workload does lead to higher fees, but these fees can be earned through outperformance, downside protection and reduced volatility.
1 For some interesting reading regarding the impact of ETFs on price discovery and volatility see:
- Gold Exchange Traded Funds and Price Discovery – An Econometric Analysis – S. Narend and M. Thenmozhi;
- Do ETFs Increase Volatility? – Itzhak Ben-David, Fisher College of Business, Ohio State University.
2 Active Share and Mutual Fund Performance – Antii Petajisto, Financial Analysts Journal, Volume 69(4). 2013.
3 How Active Is You Fund Manager? A New Measure That Predicts Performance – K. J. Martijn Cremers and Antti Petajisto, International Center for Finance, Yale School of Management. March 31, 2009.
4 2015 Summary Report for Investment Fund and Structured Product Issuers. Ontario Securities Commission. Section 3.1.2. www.osc.gov.on.ca.
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. This commentary is intended for information purposes only and does not constitute an offer to buy or sell our products or services nor is it intended as investment and/or financial advice on any subject matter and is provided for your information only. Every effort has been made to ensure the accuracy of its contents.
© Copyright PenderFund Capital Management Ltd. All rights reserved. March 2016.