What to look for in an active manager

But given the significant developments in the offerings under passive management, and the wider range of funds within the active space, it is important to be clear about what the purpose of active management should be, before commenting on whether it can add value.

Trustees should focus on having the right governance to be able to select appropriate managers

Passive management has evolved significantly over time and looks attractive in terms of the low costs and the variety of indices that are now available, including ESG and factor-based indices. 

The objective of the active managers remains the quintessential differentiating aspect between active and passive managers: active managers aim to “beat the market” whereas passive managers aim to “take the market return”. 

The definition of “market return” here is not simply the market cap index. If a scheme believes in specific factors — such as value, growth, or small cap — and that belief leads to the selection of a specific active manager, then naturally the expectation of the active manager should be an ability to pick stocks which can beat the respective factor-based benchmark.

Yet performance of active managers seems to be done, to a large extent, relative to a market cap benchmark. If we do not have enough confidence in the choice of the benchmark, then how do we know if active management is adding any real value?

Active managers have found it difficult to beat the market in recent years and globally investors have inevitably reacted to this. Morningstar statistics show that during 2016, passive strategies in the US were subject to record high collective inflows of $504.8bn (£387.7bn), whereas active funds experienced withdrawals of $340.1bn (£261.2bn). 

So, is it worth hiring active managers?

For a start, pension schemes should assess active management relative to the underlying belief that led to the appointment of an active manager, and thought needs to be given to the appropriate benchmark.  

In a simpler scenario where trustees want to generate more return than market cap benchmarks, very few active managers are able to outperform over the long term. 

The key is finding the right managers. While there are a number of measures that trustees and their advisers can take in evaluating managers, there are some traits of active managers which are more likely to generate better performance:

• A high active share and investment exclusively in the few stocks that an active manager genuinely believes in is more likely to generate outperformance than an overly diversified portfolio. 

• Morningstar research shows that there is a negative correlation between fees charged by active managers and performance. Costs should be considered against the potential value that an active manager can generate.

• In a similar vein, transaction costs result in significant loss of returns. The theoretical argument that being opportunistic while buying and selling stocks at the right time sounds easy, but high turnover strategies would need to do very well to outperform after allowing for fees and costs.

In the absence of at least one of the three points above, it is hard to see how an active manager would be able to generate outperformance over the long term. Clarity on the purpose, process and philosophy for active managers is critical to help trustees extract good value from active managers. 

Active managers are not, and should not, be considered to be identical. By definition, active managers in aggregate cannot outperform the benchmark. 

Trustees should focus on having the right governance to be able to select appropriate managers. High active shares, low turnover and lower fees are understated contributors to active returns.

Rikhav Shah is senior manager, advisory services at EY