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Why Most Active Managers Often Fall Short

A recent study by Morningstar that was discussed in a Wall Street Journal article by Sam Mamudi entitled, “Active Management Loses in Risk Study,” added further fuel to the fire of the ongoing debate over the merits of active and passive investment management strategies.  As a reminder, active investment strategies generally attempt to outperform their associated benchmark indexes while passive investment strategies generally attempt to track, or stay in line with, their associated benchmark indexes.  While it has widely been established that active mutual fund managers generally underperform their benchmark indices, the Morningstar study goes further to conclude that, on a risk adjusted basis, even more active mutual fund managers fall short.  Specifically, the Morningstar study found that over the past three years, only 37% of actively managed mutual funds outperformed their associated Morningstar indexes on a risk, size and style adjusted basis.  Put differently, 63% of actively managed mutual funds underperformed their associated Morningstar indexes over the past three years on these terms.  The results were similar over five and ten year timeframes.

These results underscore what we have believed at Hennion & Walsh for years.  In essence, we believe that when selecting an appropriate investment strategy to implement a particular component of an asset allocation plan, one should look beyond performance information alone.  For example, the following list represents some of the key factors that we include in our selection criteria:

1.     Risk Adjusted Short and Long Term Performance – measured through statistical ratios such as the Sharpe Ratio.  The Sharpe Ratio, originally introduced by William Sharpe in 1966, is measure of risk-adjusted performance and essentially conveys the amount of risk assumed to generate a unit of return.  Following this line of thinking, a high Sharpe Ratio would be deemed to be more optimal.  Just as the Morningstar study highlights, investors should feel comfortable with the overall risk that a manager assumes to beat their respective benchmark index (if in fact they are outperforming their benchmark index).  This factor is an important consideration for active and passive investment management strategies.

2.    Expenses – expenses can often eat away at investor returns and should be part of any investment strategy decision.  This factor is an important consideration for active and passive investment management strategies.

3.    Tax Efficiency – portfolios with high turnover, for example, may be less tax efficient and have a negative impact on shareholder returns in taxable accounts.  This factor is an important consideration for active and passive investment management strategies.

4.    Style Drift – we believe that it is important to select a manager for a given asset class or sector who does not try to chase returns by drifting from their stated style.  Those that do may create a negative impact on an overall asset allocation strategy.  This factor is more important when reviewing active investment management strategies than passive investment management strategies.

5.    Manager Tenure – investors should understand that they are not necessarily buying a fund but rather they are buying a portfolio manager and it is important to appreciate how a portfolio manager has performed in different market cycles.  Following this line of thinking, a long manager tenure is generally more preferable.  This factor is more important when reviewing active investment management strategies than passive investment management strategies.

After going through a rigorous selection criteria process, such as the one described in part above, an investor may find, as we have at Hennion & Walsh, that passive investment strategies such as Exchange-traded funds (“ETFs”) or Index Tracking Mutual Funds may be more appropriate for certain asset classes or sectors while active management strategies such as Active Mutual Funds or Separate Account Managers may be more appropriate for other asset classes or sectors.  As always, investors should carefully consider all alternatives before making any investment decision.

 

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