Is now the right time to be investing actively?
13 October 2017 | Portfolio construction
Commentary by Ankul Daga, senior investment strategist for Vanguard Asset Management.
Active managers have been performing well over the past few months. And some commentators suggest that the conditions are ripe for them to continue to outperform over the next few months.
So is now a good time to increase weightings in active funds?
Unfortunately the world is not that simple.
Let's get one thing clear at the start: this is not an article bashing active managers. Vanguard is known primarily as a passive manager in the United Kingdom but, globally, active mandates make up over a quarter of our assets under management (AUM) and we are one of the world's largest providers of active funds. In the UK, we have a small but growing range of active funds where we seek to combine the ingredients that we believe give investors the best chance of long-term success.
More on those ingredients later, but first let's return to the notion that now is the time to invest actively.
The reality is that active managers – both individually and en masse – have good periods and bad periods. The last few months have been good but 2016 was poor, with 82% of UK equity managers underperforming their prospectus benchmarks.1
What drives these periods of out and underperformance? First, active managers need performance dispersion at the security, sector or market level in order to create alpha: if all stocks in all markets delivered the same return, it would be impossible to outperform.
The current argument is that Brexit negotiations are likely to produce a period of heightened volatility and return dispersion, creating a fertile ground for active managers. While that argument makes sense in theory, in practice markets are very hard to predict. Memories of the Brexit vote and the 2016 US election remind us that markets often fail to follow the script provided by pundits.
So we can't state confidently that performance dispersion will rise as Brexit negotiations continue, although it does seem likely that market volatility overall will increase.
But let's suppose that markets deliver conditions that are ripe for active outperformance. This brings us to the second point: talent. Dispersed returns don't guarantee outperformance; they simply increase the range of potential outcomes for active managers – on the upside and the downside.
To succeed, managers still need to demonstrate the skill to turn that dispersion into outperformance, through stock selection, sector strategy, geographical allocation and, in the case of bonds, credit research, maturity strategy and so on.
In reality, few managers demonstrate this talent, particularly over the long term and especially after costs. But some do, and so the next challenge is to identify the ones most likely to succeed in the future. When identifying active managers to work with Vanguard focuses on the stability of the firm, the depth of support available to the managers, the philosophy of the managers and the clarity of the investment process.
Once investors have identified an active manager, they need to obtain services at a competitive cost, because low cost is the most important driver of long-term outperformance.
Having identified a talented active manager and obtained their services at low cost, investors need to exhibit discipline and patience. Performance persistence is difficult to achieve and even the best active managers suffer prolonged periods of underperformance.
For example, we looked at all the active equity funds that were available to UK investors 15 years ago and analysed their performance since that time. Of the 9% that survived and outperformed over the period, more than half had experienced three consecutive years of underperformance along the way.2
So, for active investors, patience is certainly a virtue. That's where the manager selection process comes into its own, because the greater your confidence in the manager's long-term philosophy and process, the more likely you are to stay the course.
So, is now the time to go active? History shows us that active outperformance comes and goes and past performance is certainly no guide to the future. Meanwhile, pundit predictions are often wrong and we can't be certain that market conditions will be conducive to active outperformance in the coming months.
As such, it would be unwise to try to time entry and exit points for active management. Instead, investors should think about their long-term goals and attitude to risk. Having done this, if they wish to allocate some of their portfolio to active funds, they should consider the three ingredients of talent, cost and patience that we believe provide the best chances of long-term success.
Senior investment strategist, Vanguard Asset Management
1 The figures were similarly poor in most other sectors. For example, 79% of European equity managers and 75% of US equity managers underperformed. Data reflect periods ending 31 December 2016. Source Morningstar, Inc. Prospectus benchmarks reflect those identified in each fund's prospectus. Fund performance measured in GBP, net of fees, gross of withholding tax, with income reinvested, based on closing NAV prices. Past performance is not a reliable indicator of future results.
2 Source: Vanguard calculations using data from Morningstar, Inc. The funds' returns were measured against their prospectus benchmarks. Returns cover the period 2002-2016.
This article is directed at professional investors and should not be distributed to, or relied upon by, retail investors. It is designed for use by, and is directed only at, persons resident in the UK.
The information contained in this article is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.
The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this document when making any investment decisions. Past performance is not a reliable indicator of future results.
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
The opinions expressed in this article are those of the individual author and may not be representative of Vanguard Asset Management, Ltd.
Issued by Vanguard Asset Management, Limited, which is authorised and regulated in the UK by the Financial Conduct Authority.