The “flight to passive” continues, with passively managed funds gaining $695 billion in inflows in 2018, versus $85 billion in net outflows from actively managed funds, according to Morningstar. Spurred by the inability of most active fund managers to consistently beat their benchmarks, the ongoing exodus is making it difficult for all but the most successful active managers to deliver alpha and attract new assets.
Rather than encouraging innovative thinking and thoughtful risk-taking, this trend is turning many active managers into “benchmark huggers” who try to minimize tracking error and deliver the beta-like results they believe will keep them in the upper performance deciles of their fund categories.
But sophisticated high-net worth and institutional investors don’t want to pay extra for timidity. They can leverage economies of scale to purchase inexpensive beta in the form of ETFs and index funds. If they’re going to pay more for active management, they expect these funds to outperform their benchmarks over the long haul.
And, contrary to what many in the industry believe, these investors won’t necessarily abandon active funds at the first sign of trouble. If they have faith in its investment philosophy and management team, they’ll be willing to weather periods of short-term underperformance if the overall long-term track record outperforms the benchmark and attribution of both positive and negative results is clearly communicated.
Active managers who want to boost inflows need to understand why the future for benchmark huggers is bleak and consider adopting five key strategies that may boost their chances of gaining traction among these discerning investors.
1. Embrace Unconstrained Alpha
Years of underperformance by most active funds—in no way helped by a decade-long bull market that’s favored passive investing—have created a self-fulfilling cycle of fear that is driving many active fund managers to temper their quest for alpha. They’re afraid of excess tracking error. They’re afraid of underperforming their peers. They’re afraid of low ratings from independent researchers and accusations of “style drift.”
Submitting to this fear is a losing game, since on a fee-adjusted basis very few of these funds will consistently outperform their benchmarks.
Active funds that wish to escape from this survival mentality should consider embracing the concept of “unconstrained alpha investing.” At a high level, this means using a flexible investment approach that isn’t straight-jacketed by the limitations of the fund’s asset class, style or geography.
Certain funds—like market cap-and-style-agnostic equity funds and global macro funds—have the greatest amount of freedom to invest wherever they find the best opportunities. But even core investments like large cap value funds can utilize unconstrained alpha by employing proprietary and highly disciplined research and trading processes to capture alpha before the market catches on.
Unconstrained alpha practitioners aren’t overly worried about tracking error. They’re aware that this approach won’t work under all market conditions and will sometimes lead to periods of underperformance. But they stick to their guns because they believe that, over the long-term, it will deliver superior returns.
2. Employ an Emotion-Free Investment Process
The days of “gut-reaction stock picking” are long gone. Instead, most active managers use proprietary fundamental and quantitative research methods-or a mixture of both-to identify and execute the themes they believe will deliver strong and consistent returns.
But problems often occur when short-term volatility and underperformance compel managers to tweak with their formulas, especially if their funds have relied on back-testing, rather than actual long-term returns, to validate their thinking. They lose faith in the approaches upon which they’ve staked their success and reputations. They start making emotional decisions that don’t pan out. Or, worse, they retreat to the relative safety of benchmark-hugging.
Active managers need to understand that sophisticated investors aren’t investing in a fund-they’re investing in a well-researched and highly disciplined investment process and the subject matter expertise and commitment of its practitioners. They expect portfolio managers to stick with the strategy even during times of market duress. But investors won’t stick around for managers who abandon their convictions.
One way some active managers remove emotion from the process is by employing quantitative methodologies and technical analysis to objectively identify and execute buy opportunities in undervalued securities. But that is only half the battle, utilizing a systematic approach to selling positions can alleviate the two biggest fears of most investors: exiting a position too late or (and perhaps worse) exiting too early. By delegating the trading decisions to the “quant machine,” managers remove emotion and “intuition risk” from the investment process.
3. Dare to Be Different
Scrutinize the prospectuses and marketing literature of most actively managed funds and it will be hard to discover what differentiates one from another. Most adopt variations of the “5 Ps:” performance, philosophy, people, process and portfolio. Most use similar research processes for ranking and selecting securities. Most employ similar approaches to building diversified portfolios, managing risk and executing trades. Most share similar views of the economy and the markets.
Is it any wonder that so few are able to deliver sustained excess returns and capture the attention (and assets) of investors?
In this climate, active managers need to differentiate themselves from their competitors. Those that succeed employ a variety of techniques to generate alpha and excess return.
- They deliver high active share, the percentage of fund holdings that differ from those of the benchmark index, which research shows often leads to greater alpha generation.
- They make intelligent use of risk premia, the estimation of how much a risk asset could be expected to outperform relative to a similar risk-free asset.
- They use factor investing to identify securities with characteristics that correlate with higher returns.
- And they’re not afraid to adopt contrarian attitudes that don’t align with the herd mentality.
4. Understand How Investors are Using Active Funds Today
Gone are the days when asset allocation models were populated solely with actively managed funds. Even wealthy investors, pension funds and endowments are using passively managed index funds and ETFs as core investments in each asset class and supplementing them with smaller investments in complementary active funds to achieve a blended return that may provide incremental returns that exceed their respective benchmark.
This reality has many implications for active fund managers. Since investors no longer expect them to “carry the asset class performance burden alone” they can feel more compelled to stick with their convictions. The flipside is that investors who are getting cheap beta from their passive fund positions expect active fund managers to deliver alpha-or at least to deliver returns that don’t mirror the benchmark.
5. Clearly Communicate Your Successes and Failures
In this era of “active skepticism,” downward fee pressure and heightened due diligence, delivering alpha alone is not enough. Active fund managers need to demonstrate their commitment to transparency and accountability.
Communication to both advisors and investors is an essential part of this process. Active managers need to frequently and clearly communicate not just investment results but attribution of results, down to discussions of individual trading decisions. During periods of upside alpha generation, such communication can demonstrate that performance was the result of skill rather than luck. And when the fund goes through periods of short-term underperformance, candid and detailed explanations of why the process didn’t work can help to retain investors’ trust and reduce attrition risk.
© Mount Lucas Management
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