In seeking to back up these beliefs, we conducted research on the central question of the active vs. passive debate: Can active managers add value? We sought answers by examining the performance of active managers across 14 equity asset classes¹ over the preceding one-, three-, and five-year periods² ending December 31, 2008 (after the precipitous market decline) and over the same periods ending June 30, 2007 (near the most recent peak in equity markets). These periods allowed us to test whether active managers can outperform in down and up markets.  In order to meet our definition of “adding value from active management” managers were required to beat their benchmarks by more than 20 basis points annualized after fees.³

Applying this definition, we looked at the performance of both median active managers as well as top-quartile active managers. We also conducted analysis on whether a significant number of managers could add value consistently as opposed to only at select points in time. We also examined whether there are common traits of managers that consistently outperformed. This article summarizes key findings.

Median active managers generally fell short
Proponents of passive investing often will cite the inability of an “average manager” to beat an index as a reason to invest passively. Our research across 14 equity asset classes over both timeframes described above indicated that, indeed, median active managers in most of these asset classes failed to beat their respective benchmarks,  reinforcing our belief that median managers are unlikely to add value from active management over time.

Insights Summer 2009
  

Top-quartile active managers have added value in recent years
Of course, active managers like ourselves would counter that you should not hire a median manager; you should hire a talented, significantly above-average one. The performance of top-quartile managers reinforces this point. Columns 1 and 2 of the table above illustrate that top-quartile active managers added value across nearly all of the asset classes over both study periods (up and down markets). This aggregate data suggests that top-quartile active equity managers are likely to outperform their respective benchmarks.

Evidence of ability to consistently add value among top-quartile managers
If we are correct in assuming that top-quartile active managers are likely to add value over discrete time periods, then the key question becomes whether active managers can add value consistently over time.

After all, what’s the point in hiring an active manager who has performed well in the past, if that strong relative performance cannot be repeated?  We tested this hypothesis by calculating the three-year relative performance of each active manager in these 14 asset classes over the preceding 12 quarters.⁴ We then evaluated how frequently managers in each asset class were able to beat their respective benchmarks.  In order to meet our definition of “consistent outperformance,” managers were required to beat their respective benchmarks in no fewer than 10 of the 12 observation periods.

Column 3 of the exhibit above summarizes the results of this analysis.  On average, 25% of active managers in U.S. equity categories consistently added value, while 31% and 42% of active international and global equity managers, respectively, outperformed their respective benchmarks consistently.  This evidence supports a common perception that most international markets are less efficient than the U.S. market, and therefore it may be easier for equity managers in non-U.S. categories to add value through active management. 

Active management could play a role in helping to close the retirement savings gap. The greatest challenge facing DC and DB plans worldwide is the need to close the retirement wealth accumulation gap created by low interest rates, modest returns among many asset classes, low savings rates by DC plan participants, and curtailed contri-butions/underfunded status on the part of many DB plan sponsors. There are two primary ways of closing this gap: higher contributions and higher returns – both of which are likely to be important in the years ahead.

Overall, we consider the results of our “consistent performers” analysis provide evidence that active management should play a significant role within asset allocation plans for DB and DC schemes seeking incremental returns in an effort to bridge the retirement savings gap. This recommendation applies across equity asset classes, as active managers were even able to consistently add value in US large-cap equity space – an asset class that is generally perceived to be highly efficient.

Evidence provided by this study that managers can outperform in up and down markets may also be important in convincing DC plan participants to consider investments with higher risk/return potential. One of the biggest lessons learned by DC plan sponsors in the United States over the past 30 years is that many participants have invested too conservatively, exacerbating the retirement savings gap. The introduction of higher returning auto-default options and improved investor education have been two solutions aimed at this problem that DC plan sponsors in other countries may benefit from emulating.

Another return-seeking trend that is likely to migrate from the United States to the United Kingdom and other sophisticated DC markets is a move to open architecture in target date and risk funds. Some savvy DC plan sponsors in the United States have been scrutinizing the under-lying components of proprietary target date and risk products. These sponsors seek to unbundle the glide path/asset allocation decisions from the asset management of the various underlying components (e.g., equity and fixed income investments). Sponsors are seeking incremental gains for their participants by identifying managers that are capable of adding value over the long term for each component.

This quest affirms our strong belief that demand for skilled active managers is likely to remain robust as long as managers can continue to demonstrate an ability to consistently outperform the markets over the long term.

Foot notes

1 - All data in this report was sourced from the eVestment Alliance database. We used eVestment Alliance’s pre-defined universes, which begin with the “eA” designation.

2 - While we included the five-year performance results across the 14 asset classes in this study, we do not emphasize these numbers in this article since survivorship bias and/or backfill bias may have positively skewed returns for these universes.  Accordingly, we base our conclusions on the one- and three-year numbers only which should be less biased.

3 - Management fees are based on the median fee charged for a $100 million account, according to “Mercer’s asset manager fee survey 2008.”  Median fees were 50 bp for active U.S. large-cap managers, 80 bp for active U.S. small-cap managers, and 65 bp for both active global and international managers.  Therefore, to meet our definition of adding value through active management, a U.S. large-cap manager would have to beat the Russell 1000 Growth Index by more than 70 bp annualized (50 bp fee + 20 bp “hurdle”).  We believe these assumptions are conservative because our definition not only incorporates a hurdle rate above the standard management fee, but also uses published fees, which are usually higher than the actual (negotiated) fees charged.

4The first data point, therefore, compares the three-year performance of managers versus their respective benchmarks ending December 31, 2008.
The final data point looks at the three-year relative performance of managers versus their respective benchmarks ending March 31, 2006.

5 - Consistency measured using rolling 3-year annualized returns over 12 quarters from 31-Mar-2006 through 31-Dec-2008.
Resulting % represents managers that outperformed 10 of 12 periods.

Rash Patel
Director, UK & Ireland
MFS International (UK) Ltd
0207 429 7306
rpatel@MFS.com
www.mfs.com