The constant barrage of reports about the demise of the active fund manager is relentless.
The average investor might conclude the age of active is over and it’s time to switch to low cost index-type solutions. However, more informed investors understand nothing could be further from the truth.
The coming years are likely to be a golden era for active managers. It is highly improbable the next decade will be a repeat of the last decade's smooth sailing.
Over the past 10 years, markets have experienced an incredible run with indices soaring. Momentum has been a key driver, and in times like these, fundamentals hardly matter, leading active managers to struggle to outperform.
There were many active managers who were, in reality, closet index managers. As the cost of index funds has decreased significantly, many of these managers have lost clients and been forced to close – and rightfully so.
Meanwhile, there has been a proliferation of active, with many raising too much money. It’s a well understood phenomena that if a fund manager manages too much money (relative to the size of their market) they will be unable to perform well.
Asset gatherers are insufficiently incentivised to outperform.
Many of the large Australian institutional investors withdrew from active managers and moved to index funds. Either they consider low fees to be their primary objective (with returns being a distant second), or alternatively they have defined risk as the divergence of returns from the index, rather than the risk of losing capital.
This reasoning makes sense in a bull market, where index products have outperformed high-cost active strategies. However, it is patently obvious this is nonsensical in a sideways or downwards market.
It is not a stretch to imagine the next 10 years will be a golden age for Australian active managers.
Due to the large number of closures and losses of mandates, there is far less competition for fundamental trades. This is particularly significant for small and mid-cap companies, which includes almost all of the Australian market.
And passive index-style strategies are ideal counterparties for active managers who can identify mis-pricing opportunities that index strategies create by virtue of their “dumb” trading rules.
Survive and thrive
The index trade is overcrowded. We know this as so many investors have capitulated and moved to index-type solutions. But history teaches us that overcrowded trades will inevitably unwind.
Finally, active managers tend to thrive in volatile markets – and while it would be foolish to attempt to predict the direction of the markets over the next decade, it is reasonable to assume that volatility will be higher.
Investors need to identify active managers that are well-positioned to survive and thrive.
Look for highly skilled teams or individuals with substantial experience and proven track records. Ensure they have stuck to their guns and not surrendered their investment style to pressures emanating from the extended bull market.
A credible manager will construct their strategies with an interest in downside protection and limit the amount of money they are willing to accept. I would add that such a manager defines risk as in “the risk of losing money” not “the risk of divergence from the market return”.
Good fund managers should be backed by appropriately resourced businesses so they are not faced with existential risks or operational complexity. Critically, they should not be hostage to large institutional investors who pose undue concentration risks.
While the investing masses are piling into low-cost index-type solutions, the smart money is seeking alternative managers with the above attributes.
These intelligent investors are predicting a very different decade ahead and focused on securing allocations in expert managers. Investors who are doing this are likely to be handsomely rewarded over the coming years.
Investors who are opting for low-cost solutions will inevitably realise the cheap lunch is likely to cost them dearly.
Russel Pillemer is the chief executive of Pengana Capital Group.