Hope for active portfolio managers

Pedersen takes on the famous axiom of Nobel Prize-winning American economist William Sharpe, who pointed out that before costs, the average returns for all passive and active strategies must be equivalent and that, after fees, the average passive investor will enjoy a higher return, given the lower fees.

Pedersen’s paper argues that Sharpe’s reasoning overlooks the impact of trading, which represents a hidden cost of passive investing. Trading is required by passive investors, who must buy their portfolio, then add and delete holdings as the indices change.

Under these circumstances, active management can outperform, Pedersen argues, as portfolio managers’ skill comes into play. Shrewd active managers can profit at the expense of passive strategies in assessing the value of an initial public offering (IPO), for example.

According to Pederson’s paper: “Passive investors are not guaranteed the same IPO performance as the group of active investors since they trade at different prices and quantities, thereby breaking Sharpe’s equality.” The paper adds that this holds true for secondary new issues, too.

Active managers similarly can profit by shrewdly trading on planned index additions and deletions, and from trades due to portfolio rebalancing, Pedersen states. There is a hidden cost to passive investing that stems from the trading that is required to maintain a portfolio’s balance, and this cost is “non-trivial.” The bigger the share of the market that’s passively invested, the paper states, the greater the opportunity for active portfolio managers to outperform.

Pedersen’s observations arrive at a time when active portfolio managers are going through a tough time. For example, according to Toronto-based Russell Investments Canada Ltd. (RIC), the second quarter (Q2) of 2016 was the worst on record for active managers in Canada: just 17% of managers of large-cap equities portfolios beat their benchmark in Q2 – the lowest proportion of outperformers since 1999.

Moreover, the median large-cap manager return came in at 3.4% for Q2, well below the 5.1% returned by the S&P/TSX composite index for that period.

Small-cap portfolio managers had an even tougher time in Q2. According to RIC, fewer than 3% of actively managed small-cap portfolios outpaced the S&P/TSX small cap index in Q2.

The picture for active management looks a bit better over a longer time span. For example, RIC reports, 61% of large-cap managers are beating their benchmark over a five-year period, by an average of 50 basis points.

Yet, the record is much worse when fees are factored in. In 2015, a report from Toronto-based Morningstar Canada looked at the 10-year performance records of portfolio managers of Canadian equity and Canadian small/mid-cap equity portfolios and found that more than 70% of active equity funds beat the index, and almost all (96%) of small- and mid-cap funds beat their benchmark, too.

However, the Morningstar Canada report also states that when the impact of fees is factored in, only 18% of Canadian equity funds still managed to stay ahead of the index, as almost all of the excess return that portfolio managers are able to generate appears to be consumed by fees.

Yet, while active management may be increasingly difficult to justify (Pedersen’s argument notwithstanding), Canadian investors do not appear to be fleeing en masse to passively managed alternatives. According to data from Morningstar Canada, active managers still hold a healthy lead over passive strategies in terms of assets under management (AUM).

While there is $124.8 billion invested in passive strategies in Canada as of Sept. 30, both in mutual funds and exchange-traded funds, according to Morningstar Canada, there still is $1.07 trillion devoted to active managers. And, perhaps more surprising, active managers saw their AUM grow by 9.1% over the past year, whereas passive AUM was essentially unchanged year-over-year.

Chris Davis, director of manager research at Morningstar Canada, notes that about 70% of passive products saw their AUM rise over the past 12 months. However, he notes, this increase was offset by large outflows and performance declines in the rest of the passive-fund universe.

For Canadian investors who continue to favour active management, Pedersen’s paper argues that there is good reason to believe in the ability of active managers to outperform. If Sharpe’s maxim holds true, Pedersen says, all investors should eventually gravitate to passive investing – ultimately dooming the active-management business.

“I beg to differ,” his report states. “As I have shown, active managers can profit, and more so if less capital is allocated to active. Therefore, the future of active management is not doom.”

Rather, there is room for both: “Active and passive investors can coexist in an efficiently inefficient market equilibrium, where passive investors benefit from low costs and active investors benefit from their efforts in making markets close to efficient.”

Good news for beleaguered active managers, and for the investors who believe in their skills.

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