INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES: Investment Basics: Is Active Management Still Worth the Fees? By Joseph N. Stevens, CFA INTRODUCTION As of December 31, 2014, more than 30% of all US Dollar-based mutual fund assets were managed using passively-managed investment strategies, double the percentage from ten years prior, as depicted in the chart below: Total Net Assets ($ Trillions) 15 10 5 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 40% 30% 20% 10% 0% Actively Managed % Passively Managed (Right Axis) Passively Managed Source: Morningstar; includes all US Dollar-based Mutual Funds and ETFs Passively-managed strategies, such as index funds and exchange-traded funds ( ETFs ), are relatively straightforward methods of attempting to replicate or closely track the returns of a basket of securities, such as a broad index like the S&P 500. One reason for the increased popularity of such strategies is their low fee structure. For example, an institution can invest in an S&P 500 Index Fund for an asset-based fee as low as 0.05%, compared to the median fee for an actively managed U.S. large-cap mutual fund of 0.81% 1. Another reason that passive strategies have gained popularity is that they have generally outperformed active managers in recent years. For these reasons, investors have increasingly considered if they would be better off investing in passively-managed strategies compared to actively-managed strategies. We examine whether particular market environments are better suited for active management and whether top tier managers, i.e., those capable of consistently generating returns in excess of their passive benchmarks, exist. 1 Data according to Morningstar AJG.COM
IMPORTANCE OF THE ENVIRONMENT In recent years, passively-managed strategies have generally outperformed actively-managed strategies in equity markets, however, this is not what we observe uniformly over longer periods. An active manager strives to beat the fund s benchmark over a full market cycle, which can be broadly defined as a period encompassing both bull and bear markets. Over the five-year period ended December 31, 2014, returns on U.S. equity index benchmarks were close to or above the mid-point of their corresponding manager universes, as depicted in the table below 2, an indication that passivelymanaged strategies outperformed actively-managed strategies over this period. It is important to note, however, that this period was characterized by easy monetary policy, low interest rates, and high correlations between stocks, and may represent only a portion of a full market cycle. In contrast, the fifteen-year period ended December 31, 2014, which encompasses two bull markets (2003-2007 and 2009-present), the technology bubble from 2000-2002 and the financial crisis of 2007-2008, more accurately represents a full market cycle. Over that time period, each index ranked in the bottom half of its manager universe, indicating that actively-managed strategies outperformed passively-managed strategies during this time period. Cumulative Annualized Returns through December 31, 2014 5 Years Rank 10 Years Rank 15 Years Rank Russell 1000 Index 15.64% 27 th 7.96% 51 st 4.62% 68 th Russell Mid Cap Index 17.19% 22 nd 9.56% 42 nd 8.90% 62 nd Russell 2000 Index 15.55% 52 nd 7.77% 66 th 7.38% 76 th MSCI ACWI ex US Index 4.43% 82 nd 5.13% 81 st 3.28% 71 st Source: evestment There may, in fact, be market conditions that are more favorable to either active or passive management. Generally, active management tends to benefit when more dispersion exists among the stocks within an index. Alternatively, if an index has very little dispersion, active managers have limited opportunities to exploit differences between stocks and passive management will generally outperform active management. 2 Custom universes were constructed by segregating active equity strategies within evestment into international and non-derivative-based U.S. large-, mid-, and small-cap strategies. Each universe contains at least 50 strategies over the longest measurement period. 2 AJG.COM
The two charts below depict this strong relationship between the excess returns of active management and the degree of performance dispersion across stocks. The first chart represents the U.S. large-cap universe and the dispersion among stocks within the Russell 1000 Index, represented as the Russell cross-sectional volatility index, while the second chart shows this same relationship within the small-cap universe. There are several reasons why stocks have likely become more correlated in recent years, such as the increased popularity of passive index funds and ETFs, along with central bank policies (e.g., quantitative easing) that have systematically led to higher valuations across all stocks. As stocks begin to display lower correlations, however, active managers may benefit. 17.0% 15.0% 13.0% 11.0% 9.0% 7.0% 5.0% 3.0% Large Cap: Monthly Cross Volatility & 1 Year Rolling Median Manager Excess Returns -6.0% -4.0% -2.0% 0.0% 2.0% 4.0% Cross Volatility Excess Returns (Right Axis) Source: Russell Investments, evestment 3 AJG.COM
Small Cap: Monthly Cross Volatility & 3 Year Rolling Median Manager Excess Returns 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% -8.0% -3.0% 2.0% 7.0% Cross Volatility Excess Returns (Right Axis) Source: Russell Investments, evestment TOP TIER ACTIVE MANAGEMENT Although identifying market conditions that are more favorable to active management is important, it is also important to determine if active managers have the ability to outperform over various market cycles. Using the same universes discussed previously, the table below shows the excess returns, net of fees, of each universe s top quartile and median manager relative to their passive benchmarks. Cumulative Excess Returns (through December 31, 2014) 1 Year 3 Years 5 Years 7 Years 10 Years 15 Years US Large Cap Top Quartile 0.25% 0.62% 0.21% 0.79% 0.79% 3.17% Median -1.58% -1.06% -1.10% -0.35% 0.03% 1.45% US Mid-Cap Top Quartile -1.08% -0.31% -0.17% 0.75% 0.66% 2.19% Median -4.84% -2.43% -1.65% -0.81% -0.41% 1.14% US Small Cap Top Quartile 2.04% 2.15% 1.87% 1.82% 1.46% 4.09% Median -0.68% -0.41% 0.13% 0.42% 0.58% 2.73% International Top Quartile 2.40% 3.53% 3.50% 2.59% 1.93% 2.02% Median 0.26% 1.96% 1.94% 1.53% 0.97% 1.04% Source: evestment 4 AJG.COM
The first observation is that the median U.S. large- and mid-cap equity managers have struggled to beat their respective benchmarks over the most recent ten-year period, while the median U.S. small-cap and international managers returns have outperformed. This is not surprising, given that the U.S. small-cap segment has historically been recognized as an area of the market that is less efficient compared to the U.S. large and mid-cap areas of the market, presenting investors with the potential to profit from such inefficiencies. Additionally, both the U.S. small-cap and international segments provide investors a broader opportunity set of companies than U.S. large and mid-cap universes from which to construct portfolios that are different than the index. Secondly, while the median manager s performance has varied based on the particular universe and time period, the top quartile manager s return within each universe has been higher than its relevant benchmark. In fact, the chart below shows that over rolling three-year periods the top quartile of manager returns within each universe have consistently outperformed the relevant passive benchmark. Top Quartile Manager: Rolling 3 Year Excess Returns 16.0% 12.0% 8.0% 4.0% 0.0% -4.0% US Large Cap US Mid Cap US Small Cap International Source: Russell Investment, evestment 5 AJG.COM
Another important consideration for investors is whether it is possible for managers to outperform their passive benchmarks on a consistent basis. According to a September 2014 S&P Analytics study, of the U.S. large-cap managers that generated top quartile five-year returns through September 2009, roughly one-third also generated returns in excess of their universe median over the subsequent five-year period, as depicted below: 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Persistance of Top Quartile Performance over Subsequent Five Year Periods US Large Cap US Mid Cap US Small Cap Top Quartile Second Quartile Source: "Does Performance Matter," The Persistence Scorecard, September 2014 These results indicate the challenges facing active managers to generate consistently superior returns, but support the idea that some top-tier managers do have the ability to outperform consistently. In addition, it is not realistic to expect strategies with investment style biases to remain in the top quartile under all market conditions. For example, many active strategies that focus on preserving capital will tend to invest in stable, slower-growth companies that are likely to lag in bull markets but outperform in bear markets. One method that may be useful in identifying top-tier active managers is by selecting those with high active share, which measures the percentage of a manager s portfolio holdings that differs from its benchmark. A 2009 study by two Yale professors, K.J. Martin Cremers and Antti Petajisto 3, found a strong correlation between the level of a portfolio s active share and its excess returns. 3 Cremers and Petajisto, How Active is Your Fund Manager? A New Measure That Predicts Performance 6 AJG.COM
The results of their study, which are presented in the table below, show that equity mutual funds in the top two quintiles in terms of active share outperformed their benchmarks, net of fees, from 1990-2003, indicating that strategies differing materially from their benchmark have the greatest opportunity to outperform. In 2009, Antti Petajisto updated his study 4 to include data from 1990-2009, confirming that managers with the highest active share significantly outperformed lower active share strategies and generated net returns in excess of their respective benchmarks. Mutual Fund Performance by Active Share Active Share Quintile Excess Return vs. Index (Net of Fees) Most Active 1 1.26% 2-0.25% 3-1.28% 4-0.52% Least Active 5-0.91% Source: Antti Petajisto, Active Share and Mutual Fund Performance, Financial Analysts Journal, CFA Institute CONCLUSION Active managers as a group do not outperform passive benchmarks in every market environment. An active manager s ability to outperform is dependent on the amount of dispersion among stocks within the manager s particular universe, the degree of the portfolio s active share and the investment team s skill. Over the past five years, managers have been investing in a stock market that exhibited high correlations amongst stocks relative to historical standards. As correlations decrease, the investment environment may tilt back in favor of active rather than passive management. Given the analysis of this paper, Gallagher advocates that clients utilize a core-satellite approach. This is the combination of a low-cost institutional index fund paired alongside talented active managers with a higher degree of active share. Low-cost, passive equity beta exposure has been an attractive risk adjusted strategy in the recent periods of historically high market correlations, a relentless bull market and accommodative monetary policy. 4 Antti Petajisto, Active Share and Mutual Fund Performance, Financial Analysts Journal, CFA Institute 7 AJG.COM
If market correlations return to more normal levels as monetary policy becomes more restrictive, however, a talented high active share manager would be better positioned to outperform. By employing both proper portfolio construction and manager due diligence while focusing on fees, an institutional investor can augment the returns of low-priced indexation with those of reasonably priced individual active manager expertise. 8 AJG.COM
About the Practice Joseph N. Stevens, Area Assistant Vice President, is part of the Institutional Investment & Fiduciary Services practice of Arthur J. Gallagher & Co. (Gallagher Fiduciary Advisors, LLC), focused on improving the investment program of your benefit plan and other investment pools. Gallagher s Institutional Investment & Fiduciary Services practice is a group of established, proven investment professionals who provide objective insights, analysis and oversight on asset allocation, investment managers, and investment risks, along with fiduciary responsibility for investment decisions as an independent fiduciary or outsourced CIO. Joseph N. Stevens, CFA Area Assistant Vice President Institutional Investment & Fiduciary Services joe_stevens@ajg.com 202.312.5424 JOSEPH N. STEVENS, CFA Area Assistant Vice President 2015 Gallagher Fiduciary Advisors, LLC Investment advisory, named and independent fiduciary services are offered through Gallagher Fiduciary Advisors, LLC, an SEC Registered Investment Adviser. Gallagher Fiduciary Advisors, LLC is a singlemember, limited-liability company, with Gallagher Benefit Services, Inc. as its single member. Neither Arthur J. Gallagher & Co., Gallagher Fiduciary Advisors, LLC nor their affiliates provide accounting, legal or tax advice. 9 AJG.COM