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Seeking an Active Investment Manager? Focus on These 5 Factors

By Timothy D. Paulin, CFA
Active Management Portfolio Construction Economy & Markets
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The Rise of Indexing

The average active investment manager should be expected to underperform costless indexing. Consider: The aggregate holdings of all active managers will approximate the market. So deducting fees from the equivalent of the market will naturally underperform the market.

Further, indictments of the percentage of active managers that outperform ignore that the proportion of funds outperforming has been cyclical. Recent year results certainly show that indexing (particularly in US equities) has been in favor. But that ratio ebbs and flows over time.

Moreover, assets invested in active management — despite recent outflows — remain at over $11 trillion in funds alone.1 The sheer size of many popular active funds has forced them to become less active. Indeed, we would suggest that the trends in active and passive flows make sense — even if they are for the wrong reasons.

In aggregate, investors should be questioning whether many “active” funds merit their continuing trust. The question for many is “what is a reasonable way to determine whether an active strategy is worth investment?”

Active Speaks Louder Than Words

Not all “active” funds are created equal. Identifying a distinctively active equity fund has become easier in the past decade with the widespread adoption of Active Share2 — a measure of how differentiated a fund’s holdings are from its benchmark:

  • A fund that differs from its benchmark is considered to have high Active Share (60 percent or greater depending on the asset class). 
  • A fund that mostly mirrors its benchmark has low Active Share (for instance, 20 percent). That’s not very different from the benchmark. Such funds are sometimes termed “closet indexers.”
Active Share measure matters because, in order to have the potential to surpass a benchmark, a fund must be invested in holdings that differ from the benchmark. Yet it’s important to understand that Active Share is not a measure of skill. Rather, it is a measure of how different a fund’s holdings are relative to those of the fund’s benchmark.

That makes it a precondition for differentiated performance from the benchmark but not a reflection that an active strategy merits investment.
 

5 Factors to Evaluate Active Funds

Active Share is just a starting point in the search for truly active funds worth considering (or maintaining). We believe that a fund’s Active Share measure – combined with an understanding of five important factors: a manager’s Skill, Conviction, Opportunity, Patience and Expenses (SCOPE) – helps provide a more robust method of evaluating active funds.

1. Skill

For investors seeking excellence in active management, one of the foremost challenges is the conventional wisdom that skill is entirely based on what happened through the most recent month or quarter. We believe it’s important to expand our horizon to consider the full spectrum of a manager’s history and sub-divide that history into periods such as up markets, down markets, value markets, growth markets, rolling periods, etc.

Standard industry risk measures also have flaws — especially when applied equally to all types of funds. If anything, some studies suggest that buying a fund because it performed really well lately may actually be a fine way to select UNDER-performers.

2. Conviction

Beyond being truly active and exhibiting skill, we must understand that investors generally select funds to serve a particular purpose in portfolios. Maintaining discipline and adhering to its stated investment process, style or objective is paramount to investors receiving the exposure they expect.

Conviction can also be assessed via measures such as number of holdings and concentration in top holdings. Over-diversification is a classic way that funds deal with managing too much money and reduce their opportunity to outperform. Why would we want a skilled active manager to charge us for their 400th best idea?

3. Opportunity

An active fund should allow the asset manager flexibility to implement a highly differentiated strategy, without overly restrictive constraints on characteristics such as position size, industry/sector exposure, capitalization, geographic region and tracking error. There’s a balancing act here relative to conviction — too much flexibility means we may not be getting the desired exposure; too little may hem the manager into investing in inferior positions.

4. Patience

Patience is the willingness and latitude – of both managers and investors – to wait for investments to pay off. Patient managers apply multi-year horizons to buying companies and expect the business results that occur over that horizon to generate excess returns.

Recent research by Professor Martijn Cremers, dean and finance professor at the University of Notre Dame’s Mendoza College of Business, demonstrates that highly active strategies that are also patient have delivered considerable outperformance. One readily accessible means for investors to assess patience is via portfolio turnover statistics.

5. Reasonable Expenses

There’s a reason that active management costs more — it’s more expensive to deliver. The approach requires greater investment in skilled personnel, efficient processes and advanced technology. Conversely, if a fund’s holdings merely track those of an index, there’s no point in paying active fees for something you can likely get for nearly free elsewhere.

Many investors focus on cost (i.e., fund expense ratio) and cost should be a consideration for any investor. What’s often missing from the assessment is "for what am I paying?" Active Fee adjusts expense ratio by Active Share to tell us how much we’re paying for the amount of active management we’re actually receiving. One other important consideration: remember that fund returns are reported net of fees. Assuming that an average or above-average fee necessitates underperformance is fundamentally flawed.
 

Conclusion: Putting Active Into Action

While Active Share can be a helpful measurement for investors looking for equity funds with alpha-generating3 potential, it is not designed to evaluate the performance or skills of asset managers who employ active investment management strategies. The elements of SCOPE are complementary to Active Share and supported by the academic research of Professor Cremers and others. They represent one way that Touchstone strives to overcome some of the pitfalls of fund selection and evaluation, seeking to better position clients to actively stay the course in pursuit of their long-term objectives.


1 Source: Morningstar Direct, accessed June 27, 2019.
2 Active Share measures the percentage of a fund’s holdings that differ from those of its benchmark. It is calculated by taking the sum of the absolute difference between all of the holdings and weights in the portfolio and those of the benchmark holdings and weights and dividing the result by two. Index performance is not indicative of fund performance. Investing in an index is not possible. Active Share is not a performance measurement.
3 Alpha is the portion of a fund’s total return that is unique to that fund and is independent of movements in the benchmark.

There are no assurances that any strategy or investment approach will meet its objectives. This information should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Past performance is not indicative of future results.

The expressed views and opinions herein are those of Touchstone Investments based on current market conditions and are subject to change without prior notice. There are no assurances that the opinions expressed will occur; this information is offered as a representation of a broad range of possible outcomes. This information does not take into account the specific investment objectives, restrictions, tax or financial situation of any individual. None of the information contained herein should be construed as an offer to buy or sell securities or as an investment recommendation. This information is not intended to serve as the primary or sole basis for any investment decision. It represents general market activity or broad based economic, market or political conditions and should not be construed as research.

Touchstone Securities, Inc. has partnered with Professor Martijn Cremers to provide consulting services. Touchstone and Professor Cremers are independent of each other.

Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial advisor or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.

Touchstone Funds are distributed by Touchstone Securities, Inc.*
*A registered broker-dealer and member FINRA/SIPC.

Not FDIC Insured | No Bank Guarantee | May Lose Value

About the Author

timothy paulin senior vice president touchstone

Timothy D. Paulin, CFA

Senior Vice President
Tim is responsible for product development, enriched portfolio construction and identifying, engaging and monitoring asset managers that sub-advise current and prospective Touchstone mutual funds.

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