As assets managed in passive vehicles hit new highs, reiterating the difficult task faced by traditional active managers as a group has once again become a popular pastime. We concur that the collective group will always be challenged but contend that a small segment of the group is worth it, as defined by historical and prospective success outperforming passive alternatives, net of costs and added risks.
Many managers have responded to the range of challenges in the investing environment by taking less risk over time. Predictably, fees have not fallen in lockstep, leaving many investors with a less attractive combination of full fare and muted potential. However, just as no investor’s situation is the same as another’s, not all active managers are the same. Managers that differentiate themselves with high active share or concentration have shown a higher propensity to justify an allocation of capital. Investors must consider if the managers that fit their circumstances provide reasonable active potential, as well as closely examine this in comparison to their marginal fee, to determine whether active managers are worth it for them.
Traditional active equity managers face numerous challenges. Many have been pressured by unfavorable market dynamics the last several years, like heightened pairwise stock correlation and a lower dispersion of returns between stocks. In a longer-term trend, career risk is up and the benefits from skill, according to some studies, are down. Traditional active managers’ piece of the global investor capital pie has been shrinking. As a natural reaction, many managers have toned down their active risk in an effort to reduce volatility discomfort among their investors. Additionally, as more and smarter resources are applied to active investing, the opportunities necessarily shrink.
Over time, many managers have become more like their benchmarks despite the fact that being different provides the fuel for outperformance. Active share, a measure of a portfolio’s degree of differentiation from its benchmark, is in a multi-decade decline. From 1980 to 2009, the proportion of actively managed US equity mutual funds that could be classified as “closet indexers,” or funds that don’t look significantly different from their benchmarks (defined by active share less than 60%), increased from less than 2% to 50%. Worse still, over this same period, the proportion with active share over 80% (a commonly referenced hurdle for “highly active” managers) declined from 60% to 19%.* Many managers have conceded the potential for differentiated returns to a shrinking pool of brave souls with the courage to look different. (For more on this topic, see our report Hallmarks of Successful Active Equity Managers.)
Assuming a narrow band of skill across traditional active managers, an efficient market for managers would offer a spectrum of fees that roughly approximates a portfolio’s degree of differentiation from its passive alternatives and consequently its embedded opportunity to justify its marginal fee. This is far from the case. Within the US large-cap equity universe—an area considered reasonably efficient—the median annual management fee among highly active managers is 75 bps, or 0.85 bps per unit of active share. The median among closet indexers is 60 bps, or 1.12 bps per unit. (Fees are based on our analysis of data compiled from eVestment and assuming the lowest fee vehicle option for a $10 million investment.) While the closet indexers’ total fee is lower, they have the performance hurdle of higher fixed costs per unit of potential for their less differentiated portfolio, yet this is the proposition offered by too many managers. For seekers of active management, the burden is on investors and their advisors to understand whether their choices reflect an attractive marginal fee to active risk trade-off.
Only a small collection of traditional active equity managers are worth it, and the aggregate perception of active management is often skewed by managers that likely are not. For investors with the capacity to address the challenges associated with active management, we remain advocates of seeking out those brave souls attempting to capture return potential being left on the table by those that look too much like low cost passive alternatives.
* Based on data compiled from Antti Petajisto, “Active Share and Mutual Fund Performance,” Financial Analysts Journal, 2013, vol. 69, no. 4.
Kevin Ely is a Senior Investment Director on the Cambridge Associates Global Investment Research team.