Active management isn’t dead, it’s just breathing wrong.
Reviewing an earlier 2023 study, specialist investment publication, Practical Applications (PA), concludes active strategies can outperform over the long-term if managers develop better portfolio construction habits.
Specifically, the PA report says research by Edward Aw, head of quantitative strategies for US boutique firm Bessemer Trust, suggests most active managers are undone by poor risk management rather than lack of stock-picking skills.
The PA paper says “unintended bets from portfolio construction likely overwhelm the benefit of [active manager] stock selection skills”.
“While studies have shown that managers can and do identify mispriced stocks using alpha and smart-beta strategies, the expected returns are suppressed by the managers’ failure to incorporate risk in their portfolios,” the report says.
Aw found that just under half of active large-cap US funds beat the benchmark S&P 500 but the outperformance proportion could increase significantly if managers adjust for well-known risk factors.
For example, tweaking portfolios to account for price volatility lifted the active fund index-beating ratio (after fees and costs) to 74 per cent while an equal-weighted approach saw 63 per cent outperform.
“A strong stock selection process driven by factor premiums and skill, using a systematic portfolio construction, should lead to strong longer-term relative performance versus a benchmark,” the PA report says.
The paper, and the original Aw study titled ‘The death of active management has been greatly exaggerated’, comes as the sector has been swamped by indexers. For example, Morningstar noted in January that US passive funds overtook active counterparts as measured by total assets under management for the first time in the December quarter of last year.
“Many professionals claim that the continued expansion of passive management strategies into the mutual fund industry marks the end of the active management era, while others still claim this will lead to financial instability or an inefficient market,” the PA paper says.
If Aw is right, however, active management might have some life in it yet.