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Why good active managers should outperform

The advent of cheaper and more novel financial products in the last decade has placed downward fee pressure on fund managers and focused attention on the merits of active versus passive fund management.

As an active manager at Wilson Asset Management my position is clear, but in finance, scepticism is healthy and robust debate is good for both investors and the industry. Investors should be clear about the benefits and faults of both management styles.

To me the biggest issue is that passive managers fail to provide a reasonable answer to the obvious question: with many good active managers in the Australian market, why should investors settle for benchmark returns? These active managers consistently beat the benchmark, after fees, over the longer term. Despite this fact, much of the criticism of active managers is centred on their level of management and performance fees or the cost of an active versus a passive managed portfolio, where the fees are significantly less.

Trends in the evolving market

Downward pressure on management fees during the past 10 years has been inescapable – most managers charged fees of around 1-2% in Australia whereas at one extreme, some overseas hedge funds charged as much 5%. This has fallen to an average of around 1% in Australia for plain vanilla long only equity funds. There is a growing trend towards no management fees, with performance fees only, where a fund manager backs their ability to beat the market providing a significant incentive system for investors.

However, we believe that in assessing the merits of an active manager it is important to look over the long term to see how they perform in all market cycles.

The latest Morningstar Australian Institutional Sector Survey 2015 found the average active large cap manager in Australia beat the market by 1.4% per annum over the past 10 years, whereas the average active small cap manager outperformed by 7.3% per annum over the same period. There is obviously a stronger argument for small cap management, where managers generally focus on undervalued growth companies where the overall market is far more inefficient.

Not all managers beat the market and thus investors should look for those that consistently outperform and ‘stick out’ in such surveys. It’s important for fund managers to have as flexible a mandate as possible and thus be as active as possible. Beware the index huggers who charge active fees.

Key drivers of outperformance

While performance fees are somewhat taboo for many investors, they play a key role in driving the right behaviour. Many active fund managers work incredibly long hours to stay ahead of the game due to performance incentives. This chase for alpha and constant attention on the market translates to benefits such as meeting with investee company management and participating in capital raisings.

Many of our active peers regularly meet with management to stay closely attuned to what the companies are doing and what management is thinking. It is no exaggeration that most active small cap managers spend the majority of their week meeting with company executives. Unsurprisingly, this research drives a lot of alpha and represents a serious value-add for investors who don’t have the time or access to do it themselves.

Institutional investors benefit from immediate access to trading opportunities, which can include initial public offerings, placements, block trades, rights issues, corporate transactions and arbitrage opportunities. These trades present active managers with the ability to access value quickly and regularly. As retail investors are (unfairly) excluded from directly participating in many of these deals, they can take part indirectly through active managers.

On an after-tax basis, an active manager can offer better results depending on the structure of the investment vehicle. We are advocates of the listed investment company (LIC) structure, which can pay investors fully franked dividends derived from its investee companies and additional franking credits from any tax paid from its own company profit. This means that over time, as a LIC investor, your after-tax return can be enhanced by the use of franking credits, depending on where those shares are held and your applicable tax rate.

Avoiding bad investments

Active managers earn their keep in volatile markets, especially in downturns, where the flexibility to reallocate assets and preserve capital is of a higher importance. In contrast, passive funds are forced to ride the storm and absorb the market’s losses. Similarly, active managers with a flexible mandate are able to avoid unattractive sectors and companies.

In Australia attempts to diversify by ‘buying the market’ through a passive index fund can backfire given the overrepresentation of particular sectors. Most investors would know enough from anecdotal evidence alone that resources have been a bad bet over the past few years. Worse still is an index’s exposure to banks, which make up 30% of the All Ordinaries Index. The recent large-scale sell off in the major banks following negative industry news single-handedly drove the index down.

Final words

Investors without the time or access required to successfully manage a portfolio are well placed outsourcing the task to a good fund manager with a consistent track record. An active manager will work hard to find good investments, avoid bad companies and sectors, and manage risk. The better ones will outperform the index return, which is all an investor will achieve with a passive manager. Both will charge for the pleasure, however we believe good active managers offer greater value than passive managers.

 

Chris Stott is Chief Investment Officer at Wilson Asset Management.

2 Comments
Chris Eastaway
May 28, 2015

Hi Chris,
Let me first say that I agree that in all things finance, ‘scepticism is healthy and robust debate is good for both investors and the industry’. And that ‘investors should be clear about the benefits and faults of both management styles’. But then I’m going to embrace my scepticism and point out a fault with the way active managers present their results (generally)!

I was under the impression that the ONLY metric that matters when managing other people’s money is how much you give them back! And, as a result, the performance of the manager should be measured not by how well the manager’s chosen investments perform in a vacuum, but by changes in the wealth of the investor, which only exists in an after cost/fees reality. Which is why, as you point out, much of the criticism of active managers is centered on their level of management and performance fees. Sorry. But fees matter.

In fact fees matter a lot. And active managers know it, which is why, even in your reference, the Morningstar Australian Institutional Sector Survey 2015 shows results “gross of on-going management fees and expenses”. If you live in the world of the investor, the average active large cap manager in Australia hasn’t in fact beaten the market by 1.4% pa over the past 10 years once fees are included. If an ASX traded ETF was used for the index holding is a comparative underperformance of about -.25%(ish). Which makes sense, since these funds are part of the market, and therefore part of the average when expressed through very long timeframes.

Over very long periods of time the results to the investor – not the manager – are almost certain to worsen as liquidity tolls such as portfolio turnover costs, management and performance fees compound against them. Survivorship bias is also worth a mention at this point because it inflates the results of the “average fund”. There is also the issue of finding those managers who can, and do, outperform the benchmark.

In the end, the beneficiary needs to be the investors, not the managers, for active management to stack up. So, does it? The answer might surprise me in any ‘chosen’ timeframe, but over 20, 30, 40 or 50 years I doubt it. The index can’t be better than average. But that’s not interesting. What is, is that over 50 years the market “average” is more than likely “better than the average return”. And that’s the kick.

Ron M
May 22, 2015

I must say the latest Cufflinks is a very good read, great reading trail regarding passive and active investing. I was also very interested in your article on Kerr Neilson's private meeting for the clients of a major adviser group, I found it very interesting and something I related to well.

 

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