Active managers may add value after all, according to a just-released study from the Australian-based Centre for International Finance and Regulation (CIFR), especially during bear markets.
In a statement, Ze Chen, co-author of the study alongside fellow researcher Geoff Warren and CIFR chief David Gallagher, said traditional performance analysis based on portfolio holdings misses a large chunk of active management returns delivered via tax-efficient, short-term trading efforts.
“Our analysis showed that trading made a significant contribution – between 40 and 85 bps – to fund managers’ performance – indeed the bulk of observable alpha can be attributed to interim trading,” Chen said.
The CIFR study used five years of real daily trading data from a total of 25 Australian active equity institutional managers to compare simulated portfolio returns against reconstructed pre- and post-tax returns of the S&P/ASX 300 index.
According to the study, titled ‘Data Availability Constraints in Identifying Fund Manager Skills’, the findings upend a popular notion that active management incurs a high tax burden.
“We are able to demonstrate that interim trading not only generates significant alpha, but that the additional returns are not associated with any meaningful marginal tax imposts,” the CIFR report says. “This indicates that interim trading is quite tax efficient for our sample.”
However, the study found manager outperformance shifted significantly over the January 2006 to December 2010 period covered by the trading data. The report identifies three distinct ‘market states’ during the test timeframe: the pre-GFC bull market; the GFC bear market, and; the post-GFC recovery.
According to the CIFR analysis “alpha is positive only during the bear market” with the sample funds underperforming the benchmark in both the bull and recovery periods.
“More interestingly, the contribution from trading appears strongest during the bear market (0.86% p.a. difference between daily and monthly rebalanced portfolios), followed by the bull market (0.38% p.a. difference), and weakest in the recovery market (0.13% p.a. difference),” the study says.
“These findings suggest that managers may be better able to extract alpha from trading during strongly trending markets; and that trading is relatively tax efficient.”
The CIFR study says its findings – and method using daily trading data – have important implications for how active manager performance is measured. In particular, CIFR says the analysis “unifies three strands in fund management research”: active manager performance compared to passive benchmarks; the effects of active trading, and; the impact of tax on performance.
“Addressing this intersection gets to the heart of the active/passive funds management debate,” the report says. “Trades undertaken by active managers are the means by which their insights are implemented. Our analysis addresses the question of whether these trades indicate the existence and nature of managerial skill, and how it contributes to the total after-tax returns that are realized by investors.”
CIFR collected the trading data from a total of 25 large institutional Australian active equity funds via the custodians of two major multi-manager investors.