What's the Rationale for Active Management?

(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

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.