Pinnacle became disillusioned with Strategic Asset Allocation following the “Tech Bust” at the turn of the millennium. We just didn’t believe an investment strategy that guaranteed losses in weak markets was a good solution for our clients or our business. We started to search for a better alternative.
In our search, we learned that Harry Markowitz and Modern Portfolio Theory actually recommended a more active approach to investment management by instructing investors to use expected returns, expected volatilities and expected correlations when constructing the efficient frontier and client portfolios.
The operative question for most advisors, though, is does it work? In our experience, the answer is a resounding YES! We have achieved a 10-plus year GIPS compliant and third-party audited tracked record of beating the benchmarks with less risk, net of fees and expenses.
But what about others? New academic research coming from the Yale Center of Finance – a bastion of Modern Portfolio Theory, Strategic Asset Allocation and passive investment management – also says YES! In Chapter 3 of our series, we wanted share this research with you.
“How Active Is Your Fund Manager? A New Measure That Predicts Performance”
Common wisdom is that actively managed funds have been unable to consistently outperform benchmarks in keeping with the efficient market hypothesis. So, as a practical matter, financial advisors should try to use passive index funds to replicate the benchmarks as closely as possible and at the lowest possible cost.
In their study titled “How Active Is Your Fund Manager? A New Measure That Predicts Performance”1, authors Martijn Cremers and Antti Petajisto observed that most mutual fund literature looked at the performance of mutual funds as a single homogeneous group. That made sense in the 1980s before the introduction of index funds and “closet” index funds to the data set. Since then the percentage of funds engaged in those strategies has been on the rise, crowding out the percentage of funds truly engaged in active management. And that observation begs the question: is the common wisdom that active managers are unable to consistently outperform their benchmarks still correct?
Active Share: Who is Really Engaged in Active Investment Management?
The answer could only be known by correctly identifying the funds truly engaged in active management (versus pure index fund and closet index fund investing). By understanding that active fund managers can only outperform their benchmark by investing in a portfolio substantially different than the benchmark, the authors developed a new tool called Active Share that measures the difference between a fund’s portfolio allocation and the benchmark allocation. Those with high active share are making a bet substantially different than the benchmark in an effort to achieve outperformance. Those with small differences from the benchmark — characterized as closet-index funds – are those attempting to capture the management fees of actively managed funds, but who are not making bets substantially different than the benchmark.
The authors applied the Active Share measurement to all mutual funds in the CDA / Spectrum mutual fund database for the period 1980 to 2003. In so doing, they learned that the data set was no longer homogenous and could not be treated as such. In 1980, nearly all mutual funds were actively managed. Since then, there has been a steady rise in the percentage of index funds and “closet index funds” (actively managed funds that do not own a portfolio materially different from the index) within the mutual fund universe. Clearly, conclusions regarding the whole data set are no longer reflective of actively managed funds.
Does Active Management Work?
When the authors reviewed the performance according to the improved classification of funds, they found the following:
1. Active Funds consistently outperformed the benchmarks.
2. Index funds approximated the performance of the benchmark.
3. Closet index funds underperformed the benchmark.
They also observed a difference in the performance of large funds and small funds within the High Active Share funds. Small actively managed funds outperform large actively managed funds.
According to Ken Solow in his book Buy & Hold is Still Dead (Again), “the highest performing group of funds was the group with the highest Active Share, smallest assets and the best prior one-year performance. This group outperformed their benchmarks by 6% per year, even after deducting fees and transaction costs.”
Working through the Alternatives
Fortunately, we found the solution most appropriate for our practice. Our answer may or may not suit your practice. But the decision is very much the same. We are sharing our journey with you in this series of blog posts in the hope that it helps to clarify your own decision process. Then we plan to work through another series of “Due Diligence” posts that highlight some of the things you should be looking for (good and bad) when selecting a final solution.
The slower summer months are an ideal time to work through these types of decisions / projects. We hope you find this series helpful. And of course, you should always feel free to call. We are happy to help.
1http://papers.ssrn.com/sol3/papers.cfm?abstract_id=891719
