How Active Asset Managers are Proving Their Worth

For years now, commentators and consultants have criticized the fee structure of active funds as excessive. Academics even have published studies that suggest that up to 80 percent of active funds underperform their benchmarks.

But some firms are finding ways to fight back, and the tide may be turning.

As part of the controversy over fees, hedge funds have often asserted that the only type of active management worth paying two-percent annual fees for were those that provided exposure to return factors unavailable to “traditional long-only” asset classes, such as equities and corporate bonds. However, many hedge funds have experienced poor performance over the last two or three years and have closed their funds to new investors; some even liquidated their funds.

Meanwhile, a number of large pension funds and endowments have announced that they will no longer invest in hedge products, turning instead to passive (index-tracking) funds or quantitative alternatives known as “smart beta.”

Now, there are new participants entering the fray – active managers who employ quantitative risk management techniques to target the kind of risk-return trade-off associated with traditional stock-pickers without the high fees demanded by a previous generation of “star” managers.

The stakes are enormous. Research shows that hundreds of billions of investment dollars could switch towards these new “pure factor” active products rather than be allocated passively to market index funds.

The active managers leading the fight for those investment dollars have experience with both stock picking and quantitative methodologies, and they understand why conventional, active stock selection approaches so often underperform. The problem is that risk, mostly associated with well-known factors, is not being managed effectively as active bets accumulate in a fund. Pure factor investing is a discipline where investment theory is tested against the markets, on a daily basis, with a good deal of experimental rigor.

What does it take to work in the firms taking up this challenge? Active managers are risk takers, but they calibrate their active factor exposures with the dedication of lab scientists. Their strategies are similar to those adopted by some hedge funds, with the essential addition of strong theoretically driven constraints to avoid the mistakes that commitment investors may make. To enable these strategies, factor risk models are deployed to validate the theory and to identify periods in which the theoretical notion that the “risk premium” may not be paying off. Long periods of historic testing are also mandatory to avoid jumping to investment conclusions about factors based on a few years of data.

This is the front line of active investing and, in the next year or two, we will see how pure factor strategies perform as more of these products attract pension money and take on the massive scale of competitor passive funds. The outcome could be as big a story as the rise of the passive investor was over the last 10 years.