A golden era for active managers is coming

“Performance lagging”, “clients exiting” and “funds closing” – the constant barrage of reports and articles about the demise of the active fund manager is relentless. Upon reading all this, the average investor might conclude that the age of the active manger is over and it’s time to switch to low cost index-type solutions. However, more informed investors understand that nothing could be further from the truth and that the coming years are likely to be a golden era for active managers – at least those who are well positioned to survive and thrive.

In order to evaluate the opportunity, it’s vital to understand the recent history of the industry:

• Over the last decade, markets have experienced an incredible run. With the exception of a few blips, it’s been a pretty smooth ride, with indexes soaring. Momentum has been a key driver, with more and more money being invested in specific companies and sectors. In times like these, fundamentals hardly matter and active managers struggle to outperform index-type solutions.
• There were many active managers who were, in reality, closet index managers, i.e. charging active fees but really only tracking the index. As the cost of index funds has decreased significantly, many of these managers have lost clients and been forced to close their doors – and rightfully so.
• There has been a proliferation of active with many raising too much money. It’s a well understood phenomena that if a fund manager manages too much money (relative to the size of their market) then they will be unable to perform well. A key reason why many manage too much money is that they have elected an “asset gathering” business model focussed on large institutional investors, that pay low fees in exchange for investing large amounts of funds. In this model it is more important to grow assets than to perform well.
• Many of the large Australian institutional investors withdrew from active managers and moved to lower cost index funds. The reasons for this decision have often been either because they consider low fees to be their primary objective (with returns being a distant second) or alternatively because they have defined risk as the divergence of returns from the index, rather than the risk of losing capital. This reasoning makes sense in a fast running bull market, where low cost index products have actually outperformed many high cost active strategies. However it is patently obvious that this is nonsensical in a sideways or downwards market.

Based upon this history, it is no surprise that many have concluded that the age of the active manager is over. However, this conclusion is based entirely upon the assumption that the next decade will be a repeat of the last decade with another 10 years of smooth sailing – a highly improbable outcome.

So why might the next 10 years be a golden age for Australian active fund managers?

• Due to the large number of fund closures as well as loss of mandates/investors, there is far less competition for fundamental trades. This is particularly significant for small and mid-cap companies, which includes almost all of the Australian market.
• Passive index-style strategies are ideal trading counter-parties for active managers who can identify pricing opportunities that these strategies create by virtue of their “dumb” trading rules which are exacerbated by the growth in popularity of these products.
• The index trade is over-crowded. We know this as so many investors have capitulated and moved to low cost index-type solutions. History teaches us that over-crowded trades will inevitably unwind – and are likely to result in substantial gains for skilled active managers.
• Finally, active managers generally tend to thrive in volatile markets – and whilst it would be foolish to attempt to predict the direction of the markets over the next decade, it is reasonable to assume that volatility will be higher than it has been over the past decade.

In order for investors to benefit from the structural advantages available to active managers, they need to identify those that are well position to survive and thrive. 

In their evaluations, investors should seek managers who:

• Are comprised of highly skilled teams/individuals with substantial experience and proven track records.
• Have stuck to their guns and not surrendered their investment style to pressures emanating from the extended bull market.
• Manage their strategies with an interest in downside protection.
• Have the ability and capability to invest in small or mid-sized companies.
• Carefully control their capacity, i.e. limit the amount of money that they manage.
• Are focussed on non-index returns and who define risk as “the risk of losing money” not “the risk of divergence from the market return”.
• Have a business with substantial financial resources – so they are not faced with existential risks that might cause them to make unsound short term decisions.
• Are not hostage to large institutional investors who provide poor economics and pose undue client concentration risks.
• Have extensive corporate infrastructure that is run by separate professional staff, thereby enabling the stock-pickers to avoid getting tied up in the complexity of operations.

Whilst the investing masses are piling into low cost index-type solutions, the smart money is seeking alternative managers with the above attributes. These intelligent investors are predicting a very different coming decade and are therefore focused on securing allocations in expert managers that tightly control their capacity. Investors who are doing this are likely to be handsomely rewarded over the coming years. 

Investors who are opting for low cost solutions will inevitably realise that the cheap lunch is likely to cost them dearly.