The research demonstrates that active management works best as capital moves from large caps to smaller caps, raising important questions for institutional allocators about performance and alpha attribution.
“There are lots of myths we’d like to explode today,” said David Schofield, president of the international division at Intech, a subsidiary of the fundamental house Janus Capital. “And we’d like to make a strong case for active management.”
He conceded that it had become an increasingly difficult case to make through the 1980s and 1990s, with the S&P500 annualising 17 per cent and outperforming 63 per cent of active managers.
“The cost effectiveness of active management came into question and there was a huge increase in passively managed assets,” he said, pointing out that US indexed assets grew from $416.7bn (€271.45bn) at the end of 1995 to almost $2500bn at the end of 2006, as passive investment complemented increasing allocations to alternative strategies at the expense of traditional active managers. “But the rule of thumb that average active managers underperform – apparently blindly accepted by everyone – does not seem to have held true over the last five years or so. It is an arithmetical truism rather than useful information.”
Intech research by Robert Fernholz, CIO, and Robert Garvy, shows that the likelihood of active managers underperforming is strongly linked to the relative performance of smaller caps versus larger caps.
Comparing the Capital Distribution Curve of the S&P500 with the performance of active managers over the past 40 years shows consistent outperformance as money flows into small caps and portfolios become more diversified, and underperformance as money flows into large caps, with pronounced mean reversion: the correlation was found to be 72 per cent. This led to a period of severe underperformance between 1994 and 2000, followed by outperformance until the second half of 2007.
Even the median active manager outperformed the S&P500 by 4.78 per cent between March 2000 and the end of 2007, while the top quartile posted excess returns of almost 9 per cent.
“That intuitively makes sense, as active managers have greater opportunity to express themselves through smaller-cap stocks,” said Mr Schofield.
Add the effect of compounding, and even modest outperformance begins to look compelling, particularly as the market enters a period when passive equities are not expected to offer the substantial returns seen recently. But Mr Schofield said the knowledge was most useful not for making tactical calls between passive and active allocations, but for helping to pick out how much of your active managers’ outperformance is true alpha as opposed to a smaller-cap beta effect.
“It’s only an asset allocation tool if you can predict the market movements from smaller to larger caps, or vice versa, at the inflexion point,” added Carolyn Patton, head of global consultant relations at Janus Capital Group. “It’s better regarded as a diagnostic tool for performance attribution: it reminds you that not all your managers’ outperformance may be true alpha.”
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