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The Winds of Change

November 17, 2017 | Global/Emerging Markets

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Most of the investment world seems to be asking if active managers can outperform passive managers. We believe a more appropriate question is “Where and when can active managers add value?”

Research shows that active managers can generate alpha in less-efficient asset classes (the where), and during market disruptions or transitions (the when). The challenge is identifying those active managers that are likely to meet expectations.

Where Active Management Can Add Value

In general, the less efficient an asset class is, the more opportunity it offers for active managers to create value. The characteristics that define less-efficient asset classes include lower liquidity, less comprehensive research analyst coverage, a wider opportunity set (or more variability among the universe of potential investments), and higher tracking error than the indices used by the asset class.

And, for some of the least-efficient asset classes, a well-functioning index may not exist, which makes passive investing even more problematic. Some examples of less-efficient asset classes include small cap and emerging market.

When Active Management Can Add Value

 Additionally, there are certain times that active management has tended to outperform. For example, active managers can add value when a stock-market disruption is anticipated.

That is particularly relevant today, given that we are in a notable bull market. Since the last bear market ended in March 2009, the advance we have seen in equities is the second-oldest on record without at least a 20% drop in the S&P 500 Index. In addition, market leadership has been quite concentrated. We don’t know when, and we don't know the degree of magnitude, but we will undoubtedly experience a market correction.

When that occurs, there is potential for underperformance in many passive strategies, and active managers will have the opportunity to defend some value. The median U.S. large-cap active fund, for example, provided excess returns in the two most recent market crises.

During the dot-com bubble, from 3/24/2000 to 10/9/2002, the median active fund outperformed the median passive fund by 2.27%. During the global financial crisis, from 10/9/2007 to 3/9/2009, the median active fund outperformed the median passive fund by 1.14%.1

 But the Industry Is Still in a Crisis of Relevance

 Despite the value active management has shown it can add, the industry has fallen into a crisis of relevance, because in aggregate, risk-adjusted performance net of fees has been non-differentiated relative to that of a benchmark or a passive approach.

As I explained in another post, this may simply be a cyclical reversal, but perhaps there is a more enduring reason: that the world has changed while many traditional managers, proudly clinging to their artisanal approach, have not been able to adapt to the changing dynamics, and this lack of evolution has hampered performance.

How did we get here? The winds have changed in recent years. For decades, the identification and collection of information was almost as important as the analysis of that information. Recently, regulatory changes and technological advances have shifted the paradigm.

Now the information advantage that many of us enjoyed in the past is gone, because information is now ubiquitous and commoditized, and because there are human limitations to processing all of that information.

We used to ask, “Can we get the information first?” Now we ask, “How can we sort out the valuable information and analyze it in the way that can actually add value on a sustainable basis?”

That brings us to the question: how can active managers adjust to this new reality?

How Can Active Managers Stay Relevant?

In my opinion, we must add more “science” to the “art” of investing to harness the new challenges. But talent and technology alone, while important, aren't sufficient to an asset manager's success.

Also important is the stability of the firm's operating environment, culture, and investment philosophy; the existence of a thoughtful, well-engineered investment process that has the ability to incorporate many variables; and the alignment of interests between the asset manager and investor. As an investor, it is critical to seek out managers with these attributes.

1Source: Morningstar Direct. Annualized returns calculated based on U.S. actively and passively managed true no-load mutual funds and ETFs (excluding strategic beta) in Morningstar's Large Growth, Large Blend, and Large Value categories that denote the S&P 500 Index as their primary prospectus benchmark. Past performance does not guarantee future results.