Download Active Managers are Doing the Unexpected

Thursday Thoughts
September 1, 2016
Active Managers are Doing the Unexpected
Some things aren’t supposed to happen. Like the Cubs winning the World Series or teenagers washing their own dishes. Or
active managers outperforming passive alternatives.
According to what’s floating around in the investment zeitgeist, active portfolio managers – the dinosaurs of the investment
world – are having their meteor moment. Apparently so much money is rushing into passive indexes that active managers
may need to find occupations where they can add real value - like delivering meals to tech employees or shooing Pokémon
players away from oncoming traffic.
The enthusiasm for passive investing is based on low expenses and a trainload of studies showing that active managers just
can’t beat their benchmarks after fees. No wonder investors are rushing into passive vehicles:
Assets Are Actively Leaving Managed Funds
Cumulative flows to and net share issuance of domestic equity mutual funds and index ETFs
January 2007–December 2015
1200
Index Equity ETFs
1000
Index Equity Funds
800
Active Equity Funds
Billions of Dollars
600
400
200
0
-200
-400
-600
-800
-1000
Source: Callan
But what is not supposed to happen is in fact happening. Investment consultant Callan recently released its quarterly
comparison of investment managers and benchmarks. And judging from the results, there may be a place in society for
active managers after all. In fact, according to the accompanying table, small cap managers beat their benchmarks – after
fees – most of the time.
Though this commentary has been prepared from public and private sources believed to be reliable, Ranger International Management, LP makes no warranties or
representations with respect to its accuracy or completeness. Further, the information presented herein is for informational purposes only and should not be construed
in any way as an offer to sell or a solicitation of an offer to buy any securities, investment product or investment advisory services.
Ranger International | 2828 N. Harwood Street, Suite 1900 | Dallas, Texas 75201 | (214) 871-5210 | ranger-international.com
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Thursday Thoughts September 1, 2016
The measurement period is the 20 years ending June 30. Callan calculated the percentage of small cap institutional managers
that beat their benchmarks over each rolling three year period. They even counted the percentage of managers besting the
benchmark for a given fee structure. For example, the top right corner of the table indicates that the median manager beat
the benchmark in 73% of the 3-year periods measured over those 20 years, and assuming they charged a 0.95% fee. Over
the entire period, the median manager in the Callan small cap universe beat the benchmark by 2.02% before fees:
Percent of 3-year periods over where Manager Beat Benchmark by more than Fee Hurdle – by Percentile
20-Years Ending June 30, 2016
Fee Hurdle
0.50%
0.55%
0.60%
0.65%
0.70%
0.75%
0.80%
0.85%
0.90%
0.95%
Median
45th Percentile
40th Percentile
35th Percentile
30th Percentile
25th Percentile
85%
95%
98%
98%
99%
100%
84%
93%
98%
98%
98%
100%
83%
93%
98%
98%
98%
100%
83%
91%
98%
98%
98%
100%
80%
90%
98%
98%
98%
100%
80%
89%
98%
98%
98%
99%
79%
89%
96%
98%
98%
99%
75%
89%
93%
98%
98%
99%
75%
89%
93%
98%
98%
99%
73%
88%
93%
98%
98%
99%
Average Annualized 3-Year Excess Return (Gross) – Median Manager: 2.02%
Source: Callan Historical Active Management Premiums by Asset Class and Style, Second Quarter 2016
Small cap managers were not the only ones adding value over the last 20 years. According to the Callan report, the median
micro cap manager beat the benchmark by 2.66%, and emerging market managers won out by 1.49% on a gross basis.
Some managers fared better than others. Callan’s examination of large cap managers found that the median manager
generally failed to beat the benchmark. The average annualized three-year gross excess return over the 20 years was -0.11%
before fees.
While it makes sense that large cap managers would have a tougher time beating the index given the heavy media and
analyst coverage of large cap US stocks, this may not be cause for every large cap manager to update their LinkedIn profile.
In fact, it may be a worthwhile exercise to consider why a group of well-educated large cap managers regularly underperforms
a stale list of stocks compiled by a committee.
A key reason for the disparity may be that not all active managers are equally active. More than a few managers construct
portfolios that look much like the benchmarks they seek to beat. With active fees higher than those of passive investments,
the more a portfolio looks like its benchmark, the less likely it will outperform on a net basis.
Constructing a portfolio similar to the index while purporting to be an active manager is known as “closet indexing.” It is
possible to differentiate between these closet indexers and truly active managers with a metric known as “active share.”
Active Share (which has nothing to do with portfolio turnover) measures the similarity of a portfolio to its benchmark.
Active share will range from 0% (for a portfolio that is identical to the index) to 100% (for a portfolio with no stocks in
common with the index). With this ability to measure the degree of closet benchmarking, portfolios can be segregated into
those that are truly active and those that are active in name only.
Though this commentary has been prepared from public and private sources believed to be reliable, Ranger International Management, LP makes no warranties or
representations with respect to its accuracy or completeness. Further, the information presented herein is for informational purposes only and should not be construed
in any way as an offer to sell or a solicitation of an offer to buy any securities, investment product or investment advisory services.
Ranger International | 2828 N. Harwood Street, Suite 1900 | Dallas, Texas 75201 | (214) 871-5210 | ranger-international.com
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Thursday Thoughts September 1, 2016
According to a study by Antti Petajisto, closet indexers accounted for about one-third of all equity mutual fund assets in
2009. Further, Petajisto found that funds with high active share, that is those managed by true stock pickers, on average
outperformed their benchmark over the 1980-2009 period - even after fees and expenses. Not surprisingly, the performance
of closet benchmarked funds lagged their benchmarks by about the amount of their fees. Petajisto considered a closet index
as having an active share below 60%.
Simply buying stocks that aren’t in a benchmark is hardly the silver bullet of portfolio management. But when a coherent
strategy is combined with a high active share, a manager may have a leg up on the competition.
Further, a portfolio may boast a high active share for different reasons. A concentrated portfolio will have a high active share
given the small number of stocks compared to the index. Alternatively, it is possible for a more diversified portfolio to have
a high active share if the manager is more concerned with stock picking than mimicking the index.
Investment consultants Cambridge Associates found that institutional managers running US small cap, US large cap and
non-US equity strategies with high active share beat both closet indexers as well as their benchmarks after fees over the
period reviewed.
The active vs passive approach has become a vigorous debate in and out of the investment community. But recent studies
suggest that not only can active share can be a valuable tool when evaluating investment managers, but also that the right
kind of active management can in fact deliver benchmark beating results.
Pokémon players may have to fend for themselves for just a bit longer.
Endnotes:
1.
“Historical Active Management Premiums by Asset Class and Style,” Callan, Second Quarter 2016.
2.
“Active share and mutual fund performance,” Financial Analysts Journal, Antti Petajisto, July/August 2013. The sample
included 2,740 mutual funds over the 1980-2009 period. The complete parameters of the study are detailed on page 77 of the publication.
3.
“Hallmarks of Successful Active Equity Managers,” Cambridge Associates, LLC, 2014.
Though this commentary has been prepared from public and private sources believed to be reliable, Ranger International Management, LP makes no warranties or
representations with respect to its accuracy or completeness. Further, the information presented herein is for informational purposes only and should not be construed
in any way as an offer to sell or a solicitation of an offer to buy any securities, investment product or investment advisory services.
Ranger International | 2828 N. Harwood Street, Suite 1900 | Dallas, Texas 75201 | (214) 871-5210 | ranger-international.com
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