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How Active Managers Are Fighting Back

As index funds continue to win the hearts and minds of investors, active managers are arming themselves with new tools to compete.

In a world where investors are flocking to dirt-cheap index funds and comparatively low-cost smart-beta and quantitative options, active managers are under intense scrutiny to outperform — and earn their heftier fees. To that end, they’re looking to a slew of new tools, including portfolio analytics software, to help them gain an edge in the cutthroat envrionment.  

Pension fund trustees, analysts for brokerage platforms, and other gatekeepers are increasingly tough on actively managed funds, knowing that cheap alternatives are available that might not be excellent options, but which are increasingly good-enough options, says Michael Ervolini, CEO of Cabot Research, which uses research on behavioral finance and data analysis to determine a portfolio manager’s skills when it comes to buying and selling stocks, as well their talent at sizing positions. 

“Investors have made it abundantly clear that they are no longer willing to pay substantial active management fees in return for little to no excess return above readily available passive or index products,” Ervolini says. 

He adds that active managers today feel they need to beat their benchmarks more consistently, and by wider margins, and they need to do it at a lower cost. Cabot expects that the average active manager will be expected to deliver excess returns of between 0.5 percent to 1 percent before fees annually. It estimates that fees should then be between 20 and 35 basis points. 

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In a low-return world, that means managers need to preserve their hard-won stock wins by also using more prosaic strategies, such as minimizing the bite that taxes take out of a portfolio and reducing mistakes. Firms like Eaton Vance’s Parametric offer portfolio overlay services such as tax management, for example. 

Fund managers are also increasingly using software to analyze their decision-making, Ervolini says. After collecting data for two to three years, Simon Hallett, co-chief investment officer of Harding Loevner, a Bridgewater, New Jersey-based asset manager focused on high-quality growth companies, has found that it has held onto high-performing stocks too long, something known in behavioral finance as the “endowment effect.” Part of that is because the firm has tried to keep turnover and transaction costs low. 

“We don’t want to incur the costs of selling and buying something else. That’s good, but it might also hurt us,” he says. “Now we flag stocks that have done well for portfolio managers, giving them an opportunity to justify why they’re holding them. We don’t want managers to sell positions automatically when they’ve reached a certain holding period. But we are saying that in 60 percent of cases like these, the stocks go on to underperform. Then portfolio managers have to make their minds up.” 

Damien Kohler, head of pan-European small- and mid-cap equities at BNP Paribas Asset Management in Paris, also found that the firm’s managers were subject to the endowment effect and holding some positions too long. But Kohler says the firm is now using third-party software and its own quantitative techniques to improve its stock buying process. 

“Over the last two to three years, it was harder to be good at buying the right companies,” says Kohler. 

BNP Paribas started providing more feedback to its portfolio managers on their strengths and weaknesses and tweaked its investment process for the market environment. “Active managers need to understand new quant technologies, whether something like Cabot or artificial intelligence,” says Kohler. “In the past, you were either a quant or a fundamental manager. Now you have to combine both.” 

Jon Baranko, chief equity officer at Wells Capital Management, says the dynamics of the industry are changing, and the firm is scrutinizing every process to see where it can be refined. 

“We like to generate alpha through stock selection, for example, but we’ve learned over many years that there are a lot of dynamics that can overwhelm stock selection,” he says. 

Baranko says Wells’s risk management systems now help portfolio managers understand those specific risks — and the magnitude of them.

After looking into its manager’s batting averages — how successful they are when they buy and sell — Wells Capital also found that the timing of some stock purchases were delayed. Wells Capital questioned whether it was a product of analyst meetings being drawn out and a lengthier research process. 

“We wanted to know where we were leaking alpha,” he says. In the end, the firm figured out ways to get ideas into portfolios earlier.

“You have to demonstrate that you have a process and that your results are not luck. But because excess returns are very hard to predict, it’s true that you want them to be higher than in the past,” says Hallett. 

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