While active managers can risk losing money on bad bets, a new study suggests that not taking chances could be even an even riskier strategy for them.
Research reported by the Financial Times shows that funds with many similarities to their closest benchmarks — referred to as “index huggers” — achieved almost 1.4% less in returns than their corresponding indexes over a 25-year period, according to Financial Advisor IQ.
University of Notre Dame professor Martijn Cremers, author of the study, attributes the lagging performance to low “active share” ratings, which measure how much of an active investment manager’s portfolio is uniquely put together compared to its relative benchmark. He also noted that index-hugging managers tend to charge higher fees and attract more assets.
“Unfortunately, when index huggers do attract a good deal of assets, it tends to be at the wrong time — when performance has peaked is when poor investment behaviour takes place and people gravitate to these funds,” Adviser Investments Research Director Jeffrey DeMaso told Financial Advisor IQ.
DeMaso also believes that the study supports the notion that long-term active managers tend to oversee relatively concentrated portfolios, letting them “ride their winners” and “put together portfolios designed with high levels of conviction” in their stock-picking ability.
Another takeaway from the study, according to DeMaso, is that top managers will underperform at different times. “We do tell clients that they should expect a good manager who has a concentrated portfolio and puts a lot of conviction behind his picks to fall out of favour at some point,” he said.
For RegentAtlantic Chief Investment Officer Andy Kapyrin, the most important lesson is to separate “the wheat from the chaff” among fund managers. In order for clients to avoid the ones whose long-term value doesn’t justify the added fees they charge, he recommends regularly tracking their performance against rival index funds as well as other active managers in the categories they operate in. Interviewing managers before hiring them and checking the overlap in holdings between their fund and its closest benchmark can also be useful.
Kevin Grogan, director of investment strategy at Buckingham Strategic Wealth, has taken Cremers’ study as additional evidence that stock pickers who can beat benchmarks consistently are very difficult to find, so advisors are better off dealing with bigger-picture investment issues like managing clients’ behaviours.
“Even if you believe in active management, this study should raise the question of how much active management you really want to expose your clients to at any given time,” he said.
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