Average is OK in active management

At times when markets are moving around more than usual, such as in the past three years, institutional investors tend to pay more concern to the value of active management. New global figures from Mercer show that while they should be concerned there is still value to be found in active management.

Active global equities managers have had a tough time for more than 10 years now. The global indexes have gone nowhere – slightly below zero for 10 years depending on currency denomination – and the average outperformance of active managers peaked slightly ahead of the markets at the end of 1999.

But an analysis of Mercer data indicates that the average global equities manager has still added value, at least before fees and costs, in the past three years. If your manager is only an average performer, as by definition most are, then it will be crucial to examine the after-fee after-tax numbers individually.

The Mercer figures, which are before fees, show that for its global equities universe for US$-denominated strategies, which is the largest universe, the average active manager’s excess annual return over the very long period between December 1988 and December 2009 was 2.3 per cent. This would be at least three or four times the manager fees for average mandates, which would seem worth paying for.

Smoothing those excess returns out a little more, on a three-year rolling average, the outperformance before fees was exactly the same: 2.3 per cent.

As the first chart shows, outperformance has been volatile on the 12-month rolling basis, with the two major peaks coming around the times of big market corrections: after the 1987 ‘crash’ and ‘tech wreck’ in 2000.

Similarly, as the second chart shows, the average active manager’s information ratio (returns adjusted for risk or volatility) has also been volatile, but on the smoothed out three-year basis has been sufficiently positive to justify the effort.

According to David Carruthers, a Mercer principal, it is fictitious to assume that active managers tend to outperform in down markets, which is a commonly held view.

“There’s a lot of analyses going back a long time to show that they don’t do better or worse in up or down markets,” he says. “What is more important is the cross-sectional volatility. When the markets are more volatile it does seem that the average manager is more likely to outperform.”

For instance, during the global financial crisis, when everything crashed, the average outperformance decreased, he says. But it also decreased in the previous bull market.

But investors tend to focus on the returns of their own managers and the returns of the average manager. And averages can be deceptive. Outliers at both extremes, good or bad, can have a significant impact.

“We (Mercer) think we are good at picking good managers,” Carruthers says. “We hope to do it so that the result is more than just a 50:50 bet.”

But if fees and other costs are modest, the long-term figures show that even a 50:50 bet on active management is not too bad.

Excess return in global equity from Dec 1998 - Mar 2010

Information ratio in global equity Dec 1998 - Mar 2010