Do active managers under perform due to career risk?

One of the frequently discussed topics linked to seemingly unstoppable growth of passive investing is why are active managers unable to beat their benchmarks.

Often cited reason are fees – and they definitely matter! – but as a recent blog post from CFA institute claims, it’s not only that! Based on the research, high conviction positions held by large asset managers do in fact generate return which is 3.67% p.a. better than market return. And that’s a lot!

What’s the catch then? Asset managers “play it safe” by trying to stay close to the benchmark. If a manager has a negative view on banks but there is a steep rebound in the banking sector, the index against which the manager’s performance is measured will benefit from this rebound while the manager’s portfolio won’t.

That is a real problem. Investors are impatient and underperforming funds will face outflows. As a result, many large institutions tend to deliver a return very close to the benchmark and see deviations from it as a risk.

If that sounds like a bad environment for any outperformance, I agree with you. Maybe we got to a point where large institutions, due to their internal restrictions and processes, do have a very hard time delivering any non-market returns. Be it the difficulty of actually setting up positions in sizes that matter if a portfolio gets large, or as discussed above risk of missing your benchmark.

Is specialization the only way out?

At the end of the day, this approach might make the situation worse rather than better. If a manager keeps “hugging” the benchmark, index funds will remain a better value given the costs. Aggressive specialization and niche funds might ultimately be the only way out. There’s no point in paying 2% p.a. to an asset manager to deliver a return of a globally diversified portfolio with more or less fixed weights according to the benchmark (likely MSCI World). But take a look at dividend ETFs and the story changes – dividend ETFs are often full of companies paying seemingly high and unsustainable dividends with a strong bias towards certain sectors (think energy + financials at the moment). And wouldn’t you prefer to have a specialist managing your biotechnology portfolio as opposed to a market cap weighted sector ETF? And how about that China portfolio..

Please let me know what you think about the topic in the comments below!

Published by everydayinvesting

Amsterdam based. There will definitely be a bias towards topics relevant to my work. I'm interested in investing, markets, economics, politics, history but also machine learning, statistics and how (whether) all these can be combined. I have questions and let me know if you have answers! Always happy to discuss any of the below and more. - can machine learning be applied to investing? - what's the future of active investment management? - what's the future of passive investment management? - where's the best trade now?

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