What's the Rationale for Active Management?

Active managers have struggled amid a turbulent economy, but Wellington Management believes that the tough ride for these managers may have reached an inflection point.

(November 25, 2012) — Heightened volatility has only intensified the age-old active/passive equity investing debate, Wellington Management claims.

According to one newly published paper by Wellington’s Kent Stahl, Gregg Thomas, and Tom Simon, broad weakness among active managers in US large-cap and US all-cap categories hasn’t existed since the late 1990s. As many active long-only equity managers have continually struggled to add value, questions over the purpose of active management have become more and more pronounced, the authors assert.

The authors point to the following four key market factors they say tend to expose certain structural biases in actively managed portfolios and produce a cyclical pattern in returns.

1) Narrowness of the market

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2) The spread between US and non-US performance

3) Valuation extremes for fundamentally based risk factors

4) Returns to stock-specific risk

However, the paper also notes that the strong one-way performance of these factors may be approaching an inflection point, which bodes well for the active management industry.

The paper explains: “For the first time in 14 years, all four of these factors are working against actively managed strategies simultaneously, which accounts for the remarkable similarity between today’s active manager performance and the results we saw in the late 1990s. While all actively managed strategies can be affected by these market factors, the impact is most acute in more efficient areas like the US and in narrowly defined market segments such as US large-cap growth and value.”

So what’s the rationale for selecting active management? The answer, according to the paper’s authors, is that it offers the potential for higher returns than passive management with comparable total risk. As the report explains, “active managers are ultimately paid to create portfolios that are different from their benchmark (i.e., have high active share). The resulting biases (e.g., higher stock-specific risk, valuation) affect the results of actively managed strategies in different market environments, most notably in market extremes.”

Wellington’s paper ends by outlining a number of signs pointing to why the current market environment may change. Those signs include:

1) Time: “Historically, these extreme market cycles tend to last 12 – 36 months…We are about 20 months into the current cycle. While it could last longer, given that monetary policy has limited effectiveness at this stage and there are fewer shock absorbers in the system post the global financial crisis, there is no question that this cycle is running long by historical standards.”

2) Progress on macro risks: The current cycle has largely been driven by macro risks, some of which appear to be receding, the paper asserts. At the same time, “the magnitude of the fiscal cliff in the US is so large that we expect it will drive both political parties to find some common ground post the election to avert a catastrophe.”

3) Flashing inflection-point indicators: Deeper-value contrarian stock pickers, for example, who have been at the epicenter of the issues roiling the market during the current cycle, have started to outperform — on down days in the market. Similarly, riskier areas in the fixed income markets have done incredibly well in 2012 and other recent periods. 

So, according to Wellington, active managers should stay the course, because green shoots for the industry are continuing to emerge.

Irish Pension Chief Accuses Transition Manager of “Internal Collusion”

The head of Ireland’s National Treasury Management Agency has called overcharging by State Street “fraud”; multiple sources confirm that the Financial Services Authority is investigating the bank over transition management practices.

(November 25, 2012) — “Fraud” and “internal collusion” were occurring within State Street’s transition management unit in London, according to John Corrigan—the man in charge of managing assets for Ireland’s national pension scheme.

Corrigan, the head of the National Treasury Management Agency (NTMA)—which manages investments for the National Pension Reserve Fund (NPRF)—told Ireland’s Committee of Public Accounts that State Street’s actions amounted to fraudulent acts—although he admitted that the bank would argue otherwise.

State Street had been hired by the NTMA to execute an asset transition in 2010. The fund later learned that the bank had overcharged for the transaction.

“What happened here was fraudulent in nature; we have communicated this view to State Street,” Corrigan told the committee, according to numerous media reports.

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“What we are dealing with here is fraud. Fraud, for it to be successful, has to have internal collusion,” he added. He added that, as a result, three employees were no longer with State Street.

The incident has been reported to Ireland’s police force, according to the Irish Times.

FSA Investigating

Multiple sources tell aiCIO that the UK’s Financial Services Authority (FSA) is conducting an in-depth look at State Street’s transition management practices. The FSA can neither confirm nor deny that this is occurring, as per official policy.

As previously discussed, this relates to a transition management matter that we self-reported to the FSA in September 2011,” a State Street spokesperson told aiCIO. “In a limited number of instances, we charged commissions on transition management mandates that were not consistent with our contractual agreements. As a result of our own internal analysis, we have determined that certain employees failed to comply with the high standards of conduct, communication and transparency that we expect. Those individuals are no longer with the company.”

Corrigan’s testimony before the Committee stemmed from an audit performed by Ireland’s Comptroller and Auditor General. According to the report, markups of an estimated €2.65 million—5.5 times the contractual fee—were applied to transition fees paid by the fund. This amount was fully reimbursed by State Street.

“In December 2010, the NTMA awarded…one transition contract…to London-based State Street Bank Europe Ltd (SSBE), for the disposal of assets for a management fee based on the value of the assets disposed,” the audit, released in late September, stated.  “No other compensation, other than certain foreign exchange costs, was to be paid to SSBE.” After disposing of the assets—valued at €4.7 billion—the bank collected the contracted amount of €698,000. However, “[i]n October 2011, the NTMA became aware through media reports that two senior executives, one based in the United Kingdom and one based in the United States, had departed from the transition team of SSBE,” prompting the NTMA to ask State Street for more information.

“In response, on 12 October 2011, SSBE wrote to the NTMA explaining that it had reimbursed a UK client following the application of a commission that had not been expressly agreed with the client,” the report stated.

According to the audit, in November 2011 State Street informed the NTMA that “it had concluded that a commission for which there was no contractual agreement had been applied to the NPRF transactions in transition number 14.” In December, State Street reimbursed the client “€2.65 million which was SSBE’s estimate of the aggregate amount of the mark-ups applied.”

The NTMA is not the only European fund affected. It is known that State Street also overcharged both the Sainsbury’s and Royal Mail pension plans. The bank reimbursed both funds.

Corrigan is a member of aiCIO’s Power 100.

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