During the last 18 months, the debate over this issue has raged in the financial press, with no side admitting defeat; little wonder given the huge investor flows that are at stake. In 2016, a report by S&P global highlighted that over the previous five years 91 per cent of US large cap managers had lagged the S&P 500 benchmark and 85 per cent over a ten-year period. This brought home to investors how poorly active managers have performed.
In the first half of 2016, just shy of $300bn flowed out of active managers into US based passive funds; in the first half of 2017 this has jumped to $500bn. It has been estimated that more than a third of US assets are in passive funds, up from 20 per cent a decade ago. This is certainly something that can no longer be ignored.
In this context, as investors construct their portfolio, most will need to address whether they should use an active manager or a more cost effective passive manager in its place. To help them inform this decision, it is important to establish a process that removes emotion from the argument and looks instead at how to generate the best performance with their portfolio.
Portfolio construction starts with an asset allocation where, depending on risk appetite and strategy, investors will need to determine the broad split between equities, bonds and other asset classes in their portfolio. These allocations are further divided into regional and country equity allocations or different segments of the fixed income market. Lastly, they may want to include an allocation to those alternative investments which offer attractive risk/reward characteristics.
With this broad canvas outlined, it is now time to fill in the detail to deliver the best possible returns available for each strategy. In times, past managers looked to populate the portfolio using selected third-party funds, which had outperformed their retrospective peer groups. But, these may not have outperformed the asset allocation benchmark, such as the FTSE All Share, for a number of reasons, leading portfolio to deliver sub-optimal returns.
With the arrival of passive funds this is no longer acceptable. If a fund fails to outperform the required benchmark common sense commands us to use a passive in its place, but over what time frame do we judge a fund’s performance? If we opt for too short a time frame then we will either have a bias towards passive funds or ‘core’ funds that perform more or less in line with their benchmark, or the higher conviction funds that offer the possibility of significant outperformance, but increased short term volatility, possibly leading to higher turnover and an increase in cost of dealing. After much analysis tour view on best practice is to use a rolling three-year period, with a one month step, as the basis for a comparison to ensure a fund manager has a reasonable time to perform without being traded out of for very short-term performance reasons.
For example, by treating the S&P 500 as a fund, we are able to review which quartile it would be in against the US large cap blend peer group. On a rolling three-year basis we find that it is top quartile and, for much of the time, top decile over recent years. This suggests that only one in ten US large cap blend funds have outperformed over a rolling three-year window. Moving to a one year rolling window, we find that in 2017 the S&P 500 has now moved into the second quartile, with perhaps 1 in 3 funds now outperforming; this raises the question ‘are active managers improving or is the increasing dispersion in sector and stock returns helping active managers to outperform?’
We can take this a stage further, comparing the S&P 500 to the US large cap value and US large cap growth sectors. On a rolling three-year basis in recent years, value funds have been poor relative to the S&P500, whilst growth funds performed better with several periods where the S&P would have been a second or third quartile in the growth fund peer group. To maximise efficiency, the process has been repeated to review the various growth and value passive funds available in order to assess which route we should take.
The conclusion of such an analysis is that we should have at least 60 per cent of US equity allocation in passive funds, with active managers having a growth bias, as in recent years growth had outperformed value. This review work should be ongoing in order to be able to flex the active /passive split depending on market conditions.
This process gives a framework to continually review the active/passive split, impartially determining the best implementation for an optimal portfolio.
The author is senior fund analyst at Kleinwort Hambros.
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