Closet indexers are “getting murdered” as the industry continues to embrace a large number of passive funds.
However, Brian D’Costa, founding partner at Algonquin Capital, believes this shift will sort the wheat from the chaff when it comes to true active managers.
The Toronto-based advisor, a fixed-income specialist, says he regularly fields questions about his hedge fund management fees, with investors comparing it to the cost of an ETF.
But D’Costa thinks this is exactly what an investor should be asking in order to find out if a money manager is doing anything other than just matching the index.
He said: “There are managers who purport to be active: they talk about doing credit selection or managing duration. But the problem is some of these managers are really just closet indexers so they are doing exactly what the ETF is doing except they are trying to charge twice or three times the ETF's fee.
“Those funds are going to get murdered and they are being murdered because they can’t demonstrate an edge or a reason to own them.
“Then over time, with the fee being much higher, they are going to be underperforming the ETF, so the flow of funds is leaving those types of managers. The challenge is if you want to charge a higher fee, you have to show demonstrably that you can add value. So you really HAVE to be an active manager.”
In the fixed-income market, D’Costa said that means you have to shift the credit quality of your portfolio, meaning you should sometimes be substantially in lower quality credits, sometimes more invested in higher quality credits as well as looking at how to manage your duration.
He said: “It also means as a manager you are taking some business and professional risk, which is the key because if you are wrong, not only are your investors affected but your fund could face redemption which could mean, if you are a small firm, you go out of business, or if you are in a big firm, out of a job.
“And this is the rub. Most people don’t like that risk so they become closet indexers and now the market is shifting. We think the world will end up with a large number of passive assets and active managers, who are truly active and who can demonstrate a skillset or an ability to utilize tools that other managers are not using to affect performance.”
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