With all the fanfare around exchange-traded funds, factor-based investing and robo-management, institutional investors might have forgotten that good active management can also be a worthwhile endeavour.
In her recent article “OTPP makes paying well pay off”, Amanda White pointed to the success of the Ontario Teachers’ Pension Plan, which exceeded its policy benchmark by 1 percentage point over the decade ending December 31, 2016, using good, professional active management. Canadian research covering that same decade shows that this high level of outperformance, although difficult, is attainable, even for lesser endowed funds. In fact, good, professional active management should be able to add 0.5-1.0 percentage point in value at the total fund level for most institutional investors.
First, passive management most certainly leads to slight benchmark underperformance, as even passive investing has some fees (although minimal). As a result, the value of active management should not be underestimated, particularly in these volatile, low-return markets. One hundred basis points of value added in a low-return environment – for example, 1 percentage point of a 5 per cent return, meaning 20 per cent of the total – is proportionally worth considerably more now than in previous double-digit return decades (1 percentage point of a 10 per cent return is just 10 per cent of the total). It can be the difference between first- and fourth-quartile performance.
Skill in active management is generally a function of three factors:
- Good manager or stock selection and retention
- Timely changes to strategic asset mix allocation
- Improved implementation (good execution, cash equitisation and favourable rebalancing).
Let me elaborate on the Canadian research a little further. Russell Investments has tracked actual, active manager return performance, by asset class, for more than 30 years in Canada (longer in the US). By comparing these manager returns by asset class relative to common passive benchmarks, rolling five-year, value added frequency distributions were constructed for all active managers followed. This enabled the calculation of the average median and first-quartile value added by managers in each asset category (see Table 1), for the major, liquid, traditional asset classes Canadian institutional investors commonly used over time. From that, the following table was produced, showing reasonable targets for value added, by asset class:
Table 1 – Reasonable value-added asset class targets
|Asset class (1st quartile – median = difference)||Value-added target|
|Bonds (48 bps – 18 bps = 30 bps)||40 bps|
|Canadian equities (301 bps – 118 bps = 183 bps)||150 bps|
|US equities (224 bps – 48 bps = 176 bps)||150 bps|
|Other equities (364 bps – 145 bps = 219 bps)||150 bps|
We then rolled up these active manager, bottom-up, asset class targets to the total fund level and compared them with top-down peer performance for the 10 years ending December 31, 2016. Fortuitously, most asset-class performance for that decade in Canadian dollars was about 5 per cent or below, with the S&P/TSX (Canadian equity) 10-year return at 4.72 per cent, almost identical to the FTSE/TMX (Canadian bond) return at 4.78 per cent. This allowed total fund peer comparison. The performance of three of the largest comparative institutional universes in Canada over that same decade ending December 31, 2016, is described here:
- A large money manager survey contained the performance of numerous institutional, manager, pooled funds segregated by asset class and at the total fund level (i.e., aggressive, moderate and conservative balanced funds, based on equity allocation). Their 10-year median for balanced funds ranged from 5.4 per cent (conservative) to 5.9 per cent (moderate), while the first-quartile balanced managers provided average returns between 5.7 per cent (conservative) and 6.1 per cent (aggressive).
- A major pension plan survey (PPS) we reviewed contained the performance of 88 sponsor defined benefit pension plans in Canada. Their total fund, median return for the 10 years was 6.0 per cent, while the first-quartile return was 6.4 per cent
- The Canadian Association of University Business Officers Investment Survey (CAUBO) 2016 contains the performance of university endowment funds in Canada. Their total fund, median return for the 10-year period was 5.6 per cent, while the first-quartile return was 6.1 per cent.
A number of conclusions could be drawn from this:
- Adding value to the passive benchmark, net of fees, through active management is usually no mean feat
- Nevertheless, for the 10 years ending December 31, 2016, in Canada, even the median manager in all three major, institutional, comparative surveys was able to exceed the 5 per cent passive, common index target, net of fees, at the total fund level
- First-quartile performance, usually considered a better standard for successful active management, provided even more convincing value-added performance net of fees
- The relatively few basis points in net value added through active management lead to huge total fund savings, especially when you consider the power of compound interest.
In summary, through research and factual analysis (bottom up and top down), it has been demonstrated that good, professional active management has provided 50 bps to 100 bps in added value at the total fund level, relative to a passive benchmark. Good professional, active management can add value. Perhaps this is why we are seeing even passive luminaries such as Burt Malkielac reconsidering their stance on market efficiency.
Bruce B. Curwood is director, investment strategy at Russell Investments Canada.