In Yoram Lustig’s last post, he looked at the expected capital market conditions. Today he explores the performance of active portfolio management.
Performance of active portfolio management
When markets disappoint and passive market or beta exposure does not deliver, investors often seek portfolio managers to generate returns through active security selection. An active equity manager, for instance, selects stocks and aims to outsmart the broad equity market to generate superior or excess returns above those of the passive index. But can active portfolio management compensate for the lukewarm underlying market returns?
Firstly, even brilliant active managers have limited magic up their sleeves. When a manager outperforms the market by 5% and the market falls by 10%, the investor is still left with a loss of 5%. Alpha alone is insufficient to compensate investors for falling markets. Secondly, good active managers are scarce. The odds are stacked against them and on average they fail to deliver excess returns. Numerous academic studies and financial theories agree that on average active managers lag their benchmark. The house always wins and the market normally beats the managers, not the other way around.
Beating a passive benchmark requires luck and/or skill. Luck usually runs out at some point. Skill is both rare and expensive. Most investors who tap active managers end up with average managers who lag their benchmarks after costs and fees. As the competition among active managers becomes fiercer, as the number of smart managers (e.g. hedge funds) who compete for alpha opportunities increases and as markets become more efficient (more information flow, more sophisticated players), the active management game becomes even more difficult to win.
Statistically, as the number of managers increases and fewer beat their benchmark, the chance of selecting an alpha producing manager decreases. This is one of the reasons that passive products which aim to track, not beat, benchmarks, have been gaining an increasing share of the asset pie.
These trends of increasing difficulty of generating outperformance and decreasing chances of selecting outperforming manager have three main consequences:
- Asset management firms look for new ways to make money. Single asset class products struggle to attract new assets, so firms offer new products and investment solutions. Asset management firms, like any other commercial enterprise, need to sell and make a profit to stay in business, or they go bust.
- To generate alpha or add value asset managers need more levers to pull beyond security selection. Asset allocation across a mix of asset classes, for example, is another potential source of value.
- Investors seek new ways to generate returns. Most investors are disappointed with equity or bond portfolios and demand more from their asset managers or advisers.
All these factors naturally lead to an increasing demand for multi-asset products and solutions. They attract new investors, they have flexibility and accommodate asset allocation, and they offer new lines of added value, beyond alpha from security selection. Alpha from security selection within a single asset class is typically just not enough to sustain an asset management business (with few exceptions) and to satisfy investors’ needs.
In Yoram Lustig’s next post, he will look at recent regulatory developments and conclude this series of articles about why multi-asset investing is an appropriate method for modern investing.
Yoram Lustig is the author of Multi-Asset Investing: A practical guide to modern portfolio management – available to buy from Harriman House.