Shifting the Debate on Active Versus Passive Investing
Question is Not Whether Active Equity Managers Can Beat Benchmarks – Certain Ones Can; Rather, It is Whether Investors Can, or Wish to, Embrace the Challenges that go with Investing in Differentiated Active Managers, Says New Report from Cambridge Associates
BOSTON, MA (April 29, 2014) – The debate over whether active managers can outperform their more benchmark-like peers has ceased to be productive: some active managers with certain characteristics can outperform. The key to a useful “active vs. passive” discussion is focusing on whether investment committees and their institutions can meet the challenges of implementing the differentiated managers that have the potential to outperform.
So posits a new report—“Hallmarks of Successful Active Equity Managers”—from global institutional investment firm Cambridge Associates.
“For some institutions, the challenges may be valid roadblocks, and thus make a good argument for pursing a passive approach to building an equity allocation. For others, overcoming the implementation obstacles can form the basis for a valuable relative return premium to be earned by investing with the right differentiated managers for the right time horizons,” said the report’s author, Kevin Ely, senior investment director at Cambridge Associates.
He added, “In investing, the willingness, capability, discipline, and resources to overcome implementation challenges, such as limited supply of appropriate managers and investor behavior patterns, can pave the path to more attractive results.”
Among the report’s key insights…
The perennial question of whether active portfolios can, over an investment cycle, meaningfully outperform benchmarks should come off the table. Some active portfolios can outperform. The report shows that some institutional-quality active equity managers with high active share (i.e., more differentiated from the index) and higher concentration (i.e., a limited number of portfolio holdings) have meaningfully outpaced benchmarks and peer groups. In addition, attention to risk factor exposures can help improve outcomes. In short, research shows that the more a portfolio mimics its benchmark, the harder time it has generating strong relative performance after fees.
The real question involves implementation: does the institution have the capacity and discipline for it? The report highlights several significant challenges—logistical and behavioral—to successfully implementing differentiated, active investment strategies. Among them…
- Limited supply. Institutional investors are limited to a small universe of optimal managers, and investment committees must find managers within this universe before those managers close to new investments. This sometimes requires investing with managers that lack a long, formal track record and identifying managers with the discipline to close funds before they become too large to manage in a differentiated manner.
- Higher fees and less liquidity. Differentiated managers typically charge higher fees than managers whose portfolios look more like their benchmarks. Differentiated managers sometimes also charge performance-based incentive fees, and their investment vehicles may offer less liquidity. The institution must be able to determine whether it is receiving a performance or portfolio exposure benefit that is worth the higher fees. “Our analysis indicates that, on average, the incremental performance of higher active share and more concentrated portfolios more than justifies the incremental fees. The investor must be able to accept this – and, of course, select the right managers,” said Mr. Ely.
- Investor behavior risk. Active managers with strong conviction can, by nature, be more volatile, which may create behavioral risk for investors who hire them: Volatility can prompt investors to exit at the wrong time. Studies on manager hiring and firing show that institutional investors tend to swap managers exhibiting recent underperformance in favor of managers that are doing better, only to subsequently see the performance of the fired manager improve while the new manager stalls. “Investors maximize their odds of success by remaining invested over a full market cycle, typically five to seven years,” said Mr. Ely. “Rotating managers can leave an investor running in circles and paying significant transition costs.”
“Institutions should assess their ability to manage these challenges and match their expectations with their circumstances when assessing their probability of long-term success in active equity manager selection,” Mr. Ely said. “From our perspective, investing often favors those willing to take a different path than the one of least resistance. So, for investors with a long time horizon and strong discipline, we believe investing with truly differentiated active managers may help earn a premium.”
To schedule a conversation with the author, Kevin Ely, please contact Frank Lentini, Sommerfield Communications at (212) 255-8386 / Lentini@sommerfield.com.
About Cambridge Associates
Founded in 1973, Cambridge Associates is a provider of investment services to institutional investors and private clients worldwide. Today the firm serves more than 950 global investors and delivers a range of services, including investment advisory, discretionary investment solutions, research and tools (Research Navigator and Benchmark Calculator), and performance monitoring, across asset classes. Cambridge Associates has more than 1,100 employees based in eight global offices in Arlington, VA; Boston; Dallas; Menlo Park, CA; London; Singapore; Sydney; and Beijing. Cambridge Associates consists of five global affiliates that are all under common ownership and control. For more information about Cambridge Associates, please visit www.cambridgeassociates.com.