Investors are asking active managers to produce excess returns over an increasingly shorter time period, robbing themselves of alpha, according to Boston-based asset manager MFS Investment Management.
Investors have been moving to index funds since 2008, as active managers continue to underperform their benchmarks. But MFS said in new research done for clients that stock pickers need a lot more time to prove their skill.
“A lot of money is moving to passive because they [investors] aren’t giving active the time it needs to outperform,” said Carol Geremia, president and head of global distribution at MFS, which focuses solely on active management. MFS is in discussions with clients about the time frame in which active managers need for their strategies to unfold and be successful.
“The industry is anchored around this three-year number, sometimes five years. But history tells us that you need a full market cycle, which on average is closer to 7 to 10 years, for strategies to beat benchmarks,” said Geremia. With investors increasingly focused on the short term, many asset managers have responded by compressing their investing time horizons, adding to the problem.
[II Deep Dive: How Good Policies Gone Wrong Are Killing Active Management]
The issue is not only about the index fund threat, according to MFS's research for clients. Many institutional investors are building portfolios with low-cost, liquid passive strategies on one side, balancing them with alternatives that often seek outsize returns by locking up their money for years. When investors tie up parts of their portfolios in private equity, real estate and other illiquid funds, they expect to receive a higher return for assuming that illiquidity risk.
Geremia says investors are missing out on a similar premium in public markets that can be harvested simply by extending their time horizon. In a stressed situation, institutional investors can quickly sell their positions to gain access to cash, which is much more difficult with alternative funds such as private equity.
“We need to change the conversation and talk about what matters most to protect your liquidity and to also get outperformance versus traditional benchmarks,” she said.
According to MFS, investors should focus on a statistic called holding horizon — how long a stock is held — to determine whether their own time frame is aligned with a manager’s. Similar metrics, such as portfolio turnover, are useful but don’t tell investors how committed a manager is to the underlying businesses that they own.
Geremia explained that it’s easy to forget that stocks represent an ownership in a company and most companies can’t produce real value in a short time. “Holding horizon is a great measurement to identify a manager’s skill,” she said. “Active managers allocating capital responsibly takes time.” MFS says investors can identify managers with a long-term view by looking at both active share, which measures how much a given portfolio differs from its benchmark, in conjunction with holding horizon.
Institutional investors waste considerable time working to identify top managers because they undermine their efforts by assessing them over inappropriate time frames, according to MFS. Investors essentially fire managers before they have a chance to perform.
As part of its research, MFS ranked managers based on performance over five-year periods, splitting the group into quarters. The firm found that managers' performance and rank varied widely. Only 26 percent of the top quarter of active managers focused on global equities between January 1992 and December 1996 stayed in the top quartile during the following five-year period. Results were similar for the next three succeeding five-year periods.
Citing a 2015 academic paper called A New Measure of Active Investment Management, MFS says that “long horizon funds,” which hold stocks an average of 6.85 years, outperformed short horizon funds, which only hold securities for 1.91 years. In a study of almost 3,000 equity funds between 1980 and 2010, funds with a long horizon delivered 2.4 percentage points to 3.8 percentage points more each year than short horizon funds.
But patient investors need a strong stomach to endure the ups and downs. The top quintile of managers between 2009 and 2016 spent as many as four years trailing benchmarks and their peers. “People want to know how to get alpha again. And this is how,” Geremia said of the recommendation to be patient.