A question of trust

Is active management active enough?

Over the past few years, people have been lining up to damn fund managers for offering poor returns to investors after fees. In some cases, this is completely warranted. Large amounts of capital have been managed poorly over the decades in return for charges that were too high. Clearly not all, but enough to be unacceptable.

Ironically, the cost of active investing has fallen considerably over the last few years, a period where the argument about the cost/benefit of active management has reached a crescendo. Costs are likely to continue sliding downwards as well due to increased competition and improving technology.

But there is one other area where the fund management industry must improve: it must get more active.

Too many managers make only marginal deviations from the benchmarks they are measured against, minimising relative risk but also dampening returns. This index-hugging is a symptom of a crisis of confidence, I believe, and the result of many clients being too short-term focused when they enlist investment managers. As a benchmark, investors often set modest outperformance of an index. This encourages managers to focus on making sure they deliver returns that are relatively indistinguishable from the yardstick, whether over a month, a quarter or three years. Managers want to beat the benchmark, sure. But I wonder how many would rather eke out small outperformance over all shorter-term time periods or offer substantially greater returns over a longer period with more deviation from the index.

Investors should demand more from managers, but managers should also ask for greater trust from investors. In an ideal world, active management would have a longer-term horizon of seven years or so to allow for the market cycle and style biases to iron themselves out. Meanwhile, investors would be more comfortable with volatility – knowing that greater short-term fluctuations in prices are the price you pay for higher returns.

Active managers get things wrong and make mistakes. It is not guaranteed that a manager will deliver. But that is why diversification is key. By spreading your investments you ensure that you are not hostage to the ability and fortune of one manager.

An active manager is looking at how assets within their portfolio will react to different scenarios and how that compares to the likely behaviour of other assets they hold. They are watching for the risk of having too much exposure to certain industries and thinking about how tomorrow’s world will affect the companies of today.

Passive funds are not doing that. Instead, they give investors the total risk of the index they track, whatever it is and however it changes. 

David has written a report exploring how active managers can reclaim the high ground in asset management and why active investing may be better suited to the challenges of the years ahead. If you would like to know more, please call 020 7399 0399 or email us.