A Case for Both

Art by Sam D’Orazio

“It’s almost like religion or politics: If someone is firmly on one side of the fence, you’ll never talk them over to the other side,” says Jim Sampson, director of retirement advisory services with Hilb Group Retirement Services in Warwick, Rhode Island. He refers to the decades-old debate over the merits of active vs. passive management of investment options in defined contribution (DC) retirement plans.

When active management is successful, it can add to the returns of passive funds in the broad market—or cushion losses when markets are in free-fall, such as the COVID-19-induced drop in world stock prices this February and March. There are managers that can be relied on for consistent market-beating performance, but they are rare, and a choice gone wrong can be a costly proposition for a plan’s participants. In its “2019 Active Management Review,” Wilshire Consulting reports that, among managers of large core U.S. equity portfolios, the median manager fell short of its benchmark by 0.72% annually for the five years then ended.

“For obvious reasons, it’s impossible for investors as a whole—and therefore for the average investor or speculator—to do better than the general market,” said Benjamin Graham, the patron saint of investment managers, to an audience of investors in mid-November 1963. He also observed that most of the professionally managed investment funds of the day failed to beat the market benchmarks. However, he added, “I do believe it is possible for a minority of investors to get significantly better results than the average.”

SPIVA Scorecard Results

Nearly 60 years on, in spite of all the brainpower, and financial and computational resources, thrown at the problem of investment management, reliably superior investment management is still scarce. A research team at Standard & Poor’s Dow Jones Indices has compiled the results of investment managers the world over for 18 years and dutifully reported the results—mostly dismal—in its SPIVA [S&P Indices Versus Active] scorecard. For last year, 71% of large-cap U.S. equity funds lagged the S&P 500, and, for the 10 years then ended, 89% underperformed. For 2019, in isolation, small- and mid-cap funds fared far better—62% and 68%, respectively—and outpaced their benchmarks, but only a few won over the long term.

Choosing managers is further complicated by a low persistence of outperformance. “We find that, of those managers who outperform in one year, only half go on to beat the next year,” observes Aye Soe, managing director at S&P Dow Jones Indices. “Managers need a long time to prove themselves, and we know for certain that most investors don’t have that time horizon to be tolerant.”

To be fair, there are asset classes where active management is more successful. In equities, for example, managers of international and emerging markets portfolios often show better results. Wilshire Consulting found that, last year, managers of developed ex-U.S. equity portfolios beat benchmarks by 1.26% at the median and that the median emerging markets equity manager outpaced indexes by 1.42%.

The essence of active management is building portfolios of winning securities while sidestepping the losers. The first quarter of this year provided the right circumstances, as shares of airlines, retailers and energy companies plummeted, while stocks soared for companies that profit from people staying home, as well as those working on solutions for treatment and eradication of COVID-19.

“This environment will generate a lot of ‘I told you so’ moments, and one will be whether active management is able to succeed,” Sampson observes. “Passive funds have no defense against falling markets and are at the mercy of the market on the way back up. Active managers have a choice of what they own and can do something about it.” But, he cautions, “whether they succeed or not is another matter.”

To that point, New Zealand-based Copley Fund Research reports that, for 2020’s first quarter, U.S. active equity managers posted the worst performance since 2016, lagging their benchmarks by 1.44%.

Still, many DC plans present actively managed funds alongside passive options. “As advisers, we’re agnostic on active versus indexing and think a sponsor should offer a wide array of choices to the employees,” Sampson says.

Selecting Active Funds

Given the low chances of success, how does an adviser select funds to present for a committee’s consideration? “Historical data on performance is potentially misleading for a forward-looking decision,” says David O’Meara, head of DC strategy at consultant Willis Towers Watson in New York City. “There has been plenty of research that asks whether a manager’s performance over the past five years provides insight over the next five, and the answer is ‘no.’ In many instances, outperformance can be a sell signal.

“It really takes another layer of due diligence beyond historical performance: Meeting with managers, understanding the reasons for their results, and then making a qualitative assessment on whether that historical performance is going to persist,” O’Meara says.

At Francis Investment Counsel, in the Milwaukee suburb of Brookfield, Research Director Ed McIlveen details his firm’s multilayered manager-selection process. “Our quantitative side looks at performance over full market cycles, which covers the last 10 years. We evaluate absolute and relative performance, and risk-adjusted performance through Sharpe ratios.”

A screen for consistency reveals whether managers have won more often than not, and keeps out funds that deliver extremes of performance, he says. “Our process tells sponsors whether their goals are being met versus managers’ peers or benchmarks. We can’t ask a sponsor to wait five or six years for one big year to arrive.” Francis also analyzes managers’ alpha generation versus their portfolio turnover, to determine which decisions were fruitful and when the investment process had its greatest effect.

On the qualitative side, “We need to understand why they own their stocks, and we meet with them to discuss four or five in depth. That reveals pretty quickly who knows what they are talking about,” McIlveen says. In the end, the process yields a handful of managers—about four in any category—and the names rarely change.

“It’s also important to have a way to move on from a manager,” notes Ben Taylor, senior vice president and head of tax-exempt DC research at consultant Callan, in San Francisco. “I tell my clients that if I don’t occasionally recommend to terminate a manager that is currently outperforming, I’m probably not doing my job.” In such cases, a firm might be shooting the lights out but not hewing to the style it was hired to deliver. He acknowledges that such advice can draw funny stares from clients, but “if I only tell you to terminate a manager after they have underperformed or a key portfolio manager has left, then I’m just locking in the losses after the fact.”

Jeff Stakel, a principal at Casey Quirk, a Deloitte Consulting business in Stamford, Connecticut, notes that managers have complained for years that the lack of volatility in the market created a tough environment for active management to outperform in. With the COVID-19 crisis, “Volatility has been reintroduced, and now is the time for active managers to prove their value propositions—or not. Those who can outperform will be rewarded with assets, and those who do not will be forever challenged,” he says.