Active Management: Is It Working For You?

Investment professionals that utilize actively-managed strategies employ a process that takes into account the merit, quality, substance and value of a company before making an investment decision. A direct benefit of this type of due diligence is the fact that capital is allocated prudently among the securities that trade in the secondary capital markets. As a result of this process, proponents of active investment management believe that their work ensures the integrity and credibility of the system.

Prudent Allocation of Capital
In contrast to actively-managed investment strategies, passively-managed strategies systematically allocate money in a manner that replicates the makeup of a given index proxy. In aggregate, these index strategies are harmless to the system, provided that the total amount of assets under management is relatively small. However, as index funds gain greater market share, the negative ramifications to the secondary capital markets becomes significant, because proper due diligence is diminished, which in turn hinders the integrity and credibility of the system.

When this issue is contemplated at the aggregate level, a strong case can be made that the free-rider methodology employed by the use of index funds is a violation of the prudent investor guidelines, and if utilized to a large degree, it's detrimental to the secondary capital markets. Based on this premise, representatives of publicly traded companies, public policy makers, regulatory authorities and individual investors should begin to weigh the negative long-term impact that index strategies have on the secondary capital markets, and consider the endorsement of a process that curtails the use of passive management over active management.

Common Benchmarks Used by Investors
When comparing the performance of an actively managed investment strategy to an index, it is important to ensure that a valid benchmark proxy is utilized. Let's begin by listing the seven primary benchmarks employed by investors, and then discuss their efficacy as a valid benchmark proxy.

  • Absolute benchmark proxies such as an actuarial rate of return
  • Manager universe proxies
  • Broad market indexes
  • Style indexes
  • Factor-based-model indexes
  • Returns-based indexes
  • Custom security-based indexes
Valid Benchmark Criteria
Active investment management receives a significant amount of criticism from those investors that believe risk-adjusted performance is worse for actively-managed funds than for index funds. Unfortunately, this conclusion may be wrong due to the fact that incorrect benchmark proxies have been used to compare performance and can result in a misrepresentation of results.

To address the complexity associated with the comparison of investment performance between investment vehicles and benchmark proxies, the CFA institute has published a list of criteria that a benchmark must meet in order to be considered valid. According to the CFA, a benchmark must be:

Measurable
A measurable benchmark can be quantified in numerical terms over a give time horizon. Each of the seven benchmarks listed above meets this criterion. However, there are benchmarks in which the underlying assets that make up the index are infrequently traded. In such cases, a benchmark proxy cannot be accurately measured. As a result, a comparison of the performance of an actively managed strategy in relation to this type of benchmark is not valid.

Investable
An investable benchmark means that it is possible to forgo the use of active investment management and rely on an index fund to replicate performance. Absolute performance indexes, manager universe benchmarks, and factor-model-based benchmarks violate this criterion, because there is not a comparable investment vehicle with these types of strategies. As a result, a comparison of the performance of an actively managed strategy to these types of benchmarks is not valid.

Appropriate
The appropriateness criterion ensures that the benchmark correctly measures the performance of the investment strategy. Broad-market indexes typically violate this criterion, because most investment strategies have a tailored focus. As a result, a comparison of the performance of an actively managed strategy in relation to a broad-market index is not valid, unless the investment manager utilizes an actively managed broad-market investment strategy that is comparable to the index.

Unambiguous
An unambiguous benchmark is one in which its underlying constituents are known, and their weightings in the makeup of the index is clear. Style indexes typically violate this criterion, because performance tends to be contingent upon the definition of style used by the index provider. As a rsult, a comparison of the performance of an actively-managed strategy in relation to a style index is not valid, unless it is verified that both the index provider and investment manager define style in the same manner.

Reflective of Current Investment Opinion
A benchmark which is reflective of current investment opinion is one in which the investment manager has current investment knowledge of the securities or factor exposures that make up the benchmark. Factor-based models typically violate this criterion, because investment managers do not think in terms of factor exposures when designing their investment strategies. As a result, a comparison of the performance of an actively-managed strategy in relation to a factor-based-model is not valid.

Specified in Advance
Specification means that the makeup of the benchmark is disclosed prior to the start of the evaluation period. Median manager benchmark proxies violate this criterion, because the median manager can only be established on an ex-post basis, and because the median manager will differ from one time period to the next. In addition, returns-based indexes violate this criterion, because the regression relation used to define the beta coefficients for each asset class that makes up the benchmark universe is not constant, which in turn means that it cannot be specified in advance. As a result, the performance of an actively-managed strategy, in relation to a median manager index, or returns-based index is not valid.

Able to Be Owned
The ability to own an index means that the benchmark should be integral to the investment process and procedures of the investment manager. Returns-based indexes typically violate this provision, because an unconstrained returns-based index typically produces unacceptable exposure levels to various asset classes. As a result, a comparison of the performance of an actively-managed strategy to the performance of a returns-based index is not valid.

Benchmarks that Meet the Validity Criteria
There are three types of indexes that meet all seven benchmark validity criteria. First, a broad-based index may serve as an appropriate benchmark, provided it is used as a proxy for a manager that utilizes a similar broad-based strategy. Second, a style-based index may serve as an appropriate benchmark, provided the makeup of the style index is defined in the same manner as the strategy employed by the active investment manager. Of course, the performance of both of these types of indexes should include a small reduction in performance in order to reflect a modest management fee that is required to manage money.

In addition, a custom security-based index meets all seven of the benchmark criteria. Custom security-based benchmarks are simply the research universes utilized by an investment management team that is weighted in a particular manner in order to calculate composite performance. The weightings of the securities that make up the index can be equally distributed, distributed in relation to market capitalization, or distributed in a customized fashion.

The Bottom Line
While there are many who dismiss the potential benefits of active management, investors should recognize that active investment management ensures that capital is allocated properly and in conformance with the prudent investor guidelines. In addition, there can be long-term negative ramifications to the secondary capital markets if index funds gain a greater share of the market. Finally, investors should understand that there are proper guidelines that need to be followed when comparing the performance of an actively-managed investment strategy with a benchmark proxy.

More From Investopedia

Loading...
 
Recent Quotes
Symbol Price Change % Chg 
Your most recently viewed tickers will automatically show up here if you type a ticker in the "Enter symbol/company" at the bottom of this module.
You need to enable your browser cookies to view your most recent quotes.
 
Sign-in to view quotes in your portfolios.

Market Data

  • Currencies
    Currencies
    NamePriceChange% Chg
    1.2578-0.0003-0.03%
    USDSGD=X
    1.7400-0.0002-0.01%
    EURSGD=X
    2.1134-0.0004-0.02%
    GBPSGD=X
    81.3287+0.0367+0.05%
    SGDJPY=X
    6.1644+0.0017+0.03%
    SGDHKD=X
    2.6039+0.0055+0.21%
    SGDMYR=X
    9,240.4209-15.6055-0.17%
    SGDIDR=X
    4.9713+0.0044+0.09%
    SGDCNY=X
    1.1658+0.0005+0.04%
    AUDSGD=X
  • Commodities
    Commodities
    NamePriceChange% Chg
    1,293.10+2.50+0.19%
    GCM14.CMX
    19.60-0.09-0.45%
    SIK14.CMX
    91.62-1.25-1.35%
    ^XAU
    3.120.00-0.11%
    HGK14.CMX
    101.59-0.35-0.34%
    CLM14.NYM
  • Bonds
    Bonds
    TreasuryYield (%)Yield Change
    1.74+0.03
    ^FVX
    2.690.00
    ^TNX
    3.460.00
    ^TYX

MARKET MOVERS

  • Most Actives
    Most Actives
    NamePriceChange% Chg
    2.22+0.010+0.45%
    JS8.SI
    1.16+0.010+0.87%
    U6C.SI
    0.121-0.002-1.63%
    B22.SI
    1.335-0.020-1.48%
    G13.SI
    1.2150.0000.00%
    S53.SI
  • % Gainers
    % Gainers
    NamePriceChange% Chg
    0.164+0.012+7.89%
    5HH.SI
    0.21+0.020+10.53%
    F86.SI
    0.116+0.010+9.43%
    O2I.SI
    0.72+0.050+7.46%
    5DP.SI
    1.315+0.084+6.82%
    O9A.SI
  • % Losers
    % Losers
    NamePriceChange% Chg
    0.141-0.013-8.44%
    5GD.SI
    0.151-0.009-5.63%
    A03.SI
    0.30-0.015-4.76%
    K29.SI
    1.05-0.050-4.55%
    T14.SI
    0.215-0.010-4.44%
    5UZ.SI