On Monday I ranted a bit about benchmarking and how it turns businesses and asset managers into mediocre performers. The argument I often hear in favour of benchmarking is that it limits underperformance and the damage done by inferior managers.
On the other hand, in recent years, the evidence has mounted that fund managers generate their performance almost exclusively from their high conviction overweights.
Average annual outperformance of US equity fund managers net of fees
Source: Panchekha (2019).
So, fund managers have started to create high conviction funds as a way to counteract the trend towards passive investing and closet indexing. But, a new study argues that a key problem for fund managers is that if you reduce the number of stocks in your portfolio you may need a different approach to identifying the right assets and constructing the right portfolio. This is true and I recommend this article as the first stop for those who want to become more active and think about what that means for their portfolios.
But the study also argues that being active alone is not enough to create outperformance.
That is the whole point about being very active. Both outperformance and underperformance are more accentuated, making it easier for investors to identify which fund managers are doing a good job and which ones don’t. This way the underperformers have fewer places to hide and will hopefully exit the market instead of being able to stay around for years as closet indexers convincing their clients to give them one more chance since the underperformance so far wasn’t that bad and one can catch up in the right environment (which of course is true for a truly active manager but an illusion if the fund is a closet indexer).
If the active fund management industry wants to grow its assets it needs to weed out the unskilled managers that stick around forever and are able to dupe investors year after year. And being highly active makes it harder for the truly unskilled managers to hide and easier for the truly skilled managers to shine.
In my job at Liberum, I run 10 model portfolios with 20 stocks each, so they are highly active and highly concentrated. Yet, since I launched these portfolios in spring 2020, they have outperformed their benchmark by 15% to 35% after transaction costs (and if you are interested in getting these portfolios you have to become a research client of Liberum). Obviously, a track record of 15 to 18 months in my current role is too short to draw conclusions if I am skilled or not, though my previous track record as a fund manager from 2010 to 2016 indicates that this outperformance is no accident.
Nevertheless, the point is that my highly active portfolios outperform their benchmarks by a wide margin after costs both on an absolute and a risk-adjusted basis. So being very active and running highly concentrated portfolios can add enormous value if done right and will mercilessly expose underperformers. And that’s how active management should be. It should be a marketplace for different opinions where fund managers put their money where their mouth is and where underperformers exit and make room for new entrants trying their luck. In my view, we should all encourage more active management but the tendency to benchmark fund managers does exactly the opposite and thus helps to keep the flows from active to passive funds alive and contributes to the demise of active management. It turns the investment world into a world full of mediocre funds.