Clare Flynn Levy, ex-fund manager at Deutsche Asset Management, now CEO of Essentia Analytics, writes exclusively for The TRADE about recent predictions around the demise of active fund management.
Mark Twain was actually misquoted in saying “rumours of my death have been greatly exaggerated,” but the point remains: Predictions of the death of anything tend to be wrong. The online world was supposed to signal the end of print journalism. And yet, while circulation figures have fallen from the highs of the 1990s and business/delivery models have had to evolve, newspapers are still alive and kicking. The same goes for the greatly exaggerated, and frankly often unfounded, claims that the end of active investment is nigh.
While retail investors struggle to identify true investment skill amongst active portfolio managers, and are therefore increasingly resorting to index funds as a cheaper alternative, institutional asset allocators – pension funds, endowments and the consultants who advise them – increasingly have the data and analytical tools to identify which active managers are worth their fees. And they are increasingly turning to active fund managers in this highly volatile market environment.
Having analysed the actual trade data of hundreds of active fund managers, it is clear to those with access to that analysis that not only is stock picking skill alive and well, but that it is highly identifiable to those who have access to the relevant information. There are two key stats that ultimately matter: Hit Rate and Payoff. Hit Rate is how often the fund manager’s ideas outperform the index. Payoff is the average outperformance of his or her winning picks divided by the average underperformance of his or her losers. There are certainly active fund managers who consistently produce Hit Rates below 50% and Payoffs below 100% (in other words, who consistently do worse than the index), but they’re actually not as common as many on the passive management side of the debate would lead you to believe.
Another reason institutional investors are increasingly turning to actively managed funds is that when markets are this volatile, they believe that sizing and timing skills matter. The most popular index funds involve no skill on these fronts. They are market cap weighted, so just buy more of what has been going up and sell what has been going down. While that’s worked well in a bull market, the current market dislocation is telling us that times have changed.
Meanwhile, institutional investors are aware that, thanks to that extended bull market, the most common indices have become very concentrated in a handful of stocks that are increasingly overvalued, based on fundamentals. Combine that with the fact that cap-weighted index tracker funds are ultimately just momentum strategies, investing in them is much riskier than people realise, especially right now.
There is no question that the active management industry is losing assets to passive funds, and it’s clear that the number of active fund managers in the market has been falling over time. But that doesn’t mean they won’t continue to exist. Some active managers have focused on economies of scale and cost-cutting, to ensure that the net performance differential between them and index trackers is negligible. Others have looked to technology to sharpen their investment skill – and improve their performance, as a result. As we have seen with print journalism, the most skilled – and the most adaptive – active managers won’t just survive, they will thrive.