This content is from: ThinkTank

Active Positioning for Outperformance

An Institutional Investor Sponsored Statement

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Thoughtful, prudent active management can respond to secular changes and position equity portfolios for outperformance while mitigating risk.

The active–passive debate has been raging for years, and lately, fund flow figures suggest that passive is winning. In November 2016 alone, passively managed mutual funds collected $67.7 billion of inflows, according to Strategic Insight, whereas actively managed funds sustained aggregate net redemptions of $63.9 billion.

The challenges that many active managers face in seeking to generate excess returns net of fees and other costs have been widely documented. “The academic research is, for the most part, irrefutable when you look at active management collectively,” says Rob Sharps, co-head of global equity at T. Rowe Price. “But it is clear that if you do some screening you can identify certain characteristics that meaningfully increase the odds of active management outperforming the benchmark.”

Reviewing the performance of 19 of its institutional diversified active U.S. equity strategies over 20 years, T. Rowe Price discovered that they did generate positive excess returns, net of fees, versus their designated benchmarks over rolling one-, three-, five-, and ten-year periods (see sidebar, opposite). As the time periods were extended, the likelihood of outperformance grew. Active U.S. equity managers demonstrated a better chance of outperforming during bear markets and were even found to provide a measure of downside risk mitigation. Active also outperformed passive during periods when markets displayed high return dispersion.

“Part of the reason why the trend toward passive has accelerated is that, collectively, active management didn’t do a very good job of risk management in the global financial crisis,” says Sharps. “But historically, the more difficult market environments have been times when good active managers can and should be able to differentiate themselves.”

Skilled, risk-aware active management has the potential to add value over longer time horizons through techniques like security selection, sector rotation, and factor weighting. Foresightful active managers also benefit from the ability to incorporate major disruptions caused by technological innovation and changes in societal trends into their thinking. Passive investing strategies do not have that capability, and may come with unintended risks. Market-cap-weighted indexes, like the Standard & Poor’s 500, have a built-in momentum bias. Neither do passive investing strategies anticipate bubbles or other market events.

“Those are the sorts of environments that give active management the opportunity to position itself to outperform,” Sharps says. Changes in economic regime, especially, create opportunities for active managers to anticipate new opportunities and adapt dynamically. — Howard Moore