Investing in the US Part 4

Elisa Trovato: In a market which is traditionally very efficient, like the US market, do you prefer actively or passive funds, and what kind of active managers do you select in this area?

Lance Peltz: We all know the US is very efficient. It is a market where we are more willing to use exchange traded funds (ETFs) to a much greater extent than any other space. There are times when active managers really struggle. We have worked hard to try to create a model that would be predictive of that; unfortunately, so far we have not had much success. Last year, active managers struggled. I think the S&P 500 would have ranked top of the second decile among funds. In the US, we have a portfolio-construction philosophy where we try to minimise the risk of underperformance by anchoring in ETFs and, if we have a strong view about style, we will allocate to styles where we are more willing to use active managers, as we believe an active manager has more chance of outperforming.

Mouhammed Choukeir: If we have a client who wants US equities, the debate about passive versus active is quite relevant, because the question is, ‘Do we want US equities cheaply using a passive fund or do we want a high-tracking-error active fund?’ If you have a client who is multi-asset-class in nature – and a lot of clients are –that decision plays a lesser role relative to the asset mix that you have between equities, bonds and commodities, etc.

Efficiency is one argument, but the other is that what we have seen since the crisis broke out is the increase in correlation, not just at the stock level, but at the sector level and at the country level. Stockpickers have a really tough time, as they increasingly have the challenge of either being risk-on or risk-off. Also, there is US managers’ willingness to take tracking error relative to a benchmark. In the US, there is a herd mentality whereby many of them do not take big deviations around some of their benchmarks. In other markets, some actively take it; some have no choice, because it happens naturally, due to the high volatility and the correlations, so the opportunity set is much bigger outside of the US.

Bill McQuaker: I think this notion that the US market is superefficient is questionable. The view is based on the fact that the average manager does not beat the S&P. The average manager these days turns his portfolio over to an extraordinary degree in the US. The holding period is down to about a year for the average manager. There is a lot of trading cost being borne by these funds, and then there are fees and the like on top, so it is no big surprise that the average manager trails the S&P.

When we talk about active management, ‘active’ is not a short word meaning ‘activity’, but it is about having a portfolio structure that is significantly different from the market average or from the index, where turnover is low, and where the drivers are fundamental rather than short-return or more technical in nature. Those things in combination have often been consistent with better performance.

The second point is that the US money-management market has taken on a structure which is very ‘structured’. An investment may be attractive but does not get into the portfolio because if the fund does not keep its characterisation, clients and consultants will desert it, which is a problem, so the investment opportunity is ignored. This is particularly extreme in the US.

Oliver Gregson: You are getting to the crux of a point which is: what are the incentives for the manager?  Am I going to lose my mandate and my assets if I do not deviate too massively from my benchmark?

Bill McQuaker: It is managing business risk rather than the investment.

Oliver Gregson: This comes back to the point about whether that is active management. That is especially important for us, because beta is cheap, so if I just want to get beta or benchmark, I am going to use passive securities to do that. I would far rather pay active-management fees for someone whose active share within their fund is that much higher.

Our philosophy on that is top-down and bottom-up. In terms of top-down, we will tend to use passive securities in three situations: when we think the alpha environment might be a little more scarce; that could be if you are investing in an S&P 500, when stock correlation is very high, or when individual components of a market are less liquid.

We primarily use passive a lot of the time for all of our short-term TAA calls, because ETFs are quick to transact, cost-efficient, cheap and transparent. Lastly, we might use ETFs or passive securities in some less easily investible markets, like Vietnam, etc, because it is difficult to find active management there.

Complement that, then, with the bottom-up and with the managers who you choose. The philosophy that we apply there is probably that we think the industry overly relies on past performance. We think that asset growth does impede future returns. 

Lance Peltz: The biggest challenge we have is that, in the universe of non-style-driven, flexible, go anywhere US equity managers, we have found very low persistence in performance relative to a benchmark. We can talk about the drawbacks of benchmarks and so on, but it helps us model portfolio construction whereas we have found greater persistence and visibility. So we went about visibility, expected performance patterns and persistence with more style-driven managers, like a large-cap growth manager, when you know what you are going to get.

Bill McQuaker: Relative to the S&P, we have found persistence with unconstrained, fundamentally driven managers who are good at what they do. Everyone claims to be fundamentally driven. There are people who understand the fundamentals of companies and the dynamics of markets better than others. If you take those people, give them an unconstrained mandate, they can deliver persistently good returns.

Stefano Spurio: Maybe it is also a lesson that all institutions and clients derived from this crisis. Before, there were a lot of expectations about active management, to the extent that it fed the hedge fund industry as well. Now there is a willingness to use hedge fund-like strategies the long-only world. At the same time, institutions are now focusing on asset allocation internally, and that is why the use of ETFs is increasing. Before, it was only US institutional investors and now, over the last five to seven years, we have increasingly seen it elsewhere in the investment world. We have seen those trends impacting the way banks think about their investment process.

Grant Bughman: That is a very good point. You touched upon it earlier: a large percentage of managers in the US are closet indexers. For us, we have 45 stocks in our portfolio. Our tracking error does not tend to run exceedingly high, but it is not low, and so our clients are hiring us to take bets that we think have good risk and return, and the ability to seek to outperform. I think most managers do not have that technical mindset. They think we can have 50 basis points above the S&P 500, give or take, and make a good business.

Lars Kalbreier: Regarding asset managers who can outperform in the long run, the key is to find managers who take active bets with conviction. We look at the tracking error that managers take and, if the tracking-error budget has been just too low over time, we believe that the manager does not have the confidence to take active bets; hence, we would prefer ETFs.

We learn that active managers tend to underperform the benchmark after costs, but the benchmark is theoretical, so what you need to compare it to is an ETF that is investible. That changes the situation depending on the asset class. An ETF will never be able to replicate the benchmark totally.

Also, if you take the whole universe of fund managers and look at how many passive managers in disguise you have, if you start stripping these out, the comparisons start to look more favourable for active managers. That is why it is important that we educate our clients about what active management really means.

Elisa Trovato: Are there any specific market cycles where active managers have a better chance of generating excess return?

Grant Bughman: Yes, I think the whole ETF/hedge fund/high frequency trading phenomenon currently gives us an environment where, as an active manager, because everything moves in the same direction, you have the ability to significantly add alpha for clients.  If the market is trading – and there is very little liquidity at this moment – it has a similar impact on all types of stocks.  By definition, not all companies are going to be traded equally, so the valuation opportunities are going to be larger.