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Active management: science or guesswork?

In a turbulent and unpredictable world, can active management really add value compared to passive investing? Matthew Brittain, Sanlam Private Wealth’s Macro Analyst, discusses the growing popularity of trackers, and why there will always be a need for an active approach. 

 

There’s no denying that passive investing and its cousin, ‘smart beta’, are in vogue at the moment, attracting more than a billion dollars of in-flows a day. Earlier this year, Moody’s Investors Service predicted that passive investments will outstrip active by 2024 at the latest. So what does this mean for active investments? Ironically, great things, in my opinion.

Good versus great

Active management has had its fair share of criticism over the years, and rightly so in many cases. By holding investments that very closely represent a benchmark, it shouldn’t come as a surprise that their performance will cluster around a mean. While this means that returns are close enough to the peer group, and therefore neither exceptional nor dreadful, this approach guarantees investors average performance. And, if all investors want is average performance, then they absolutely should buy an index tracker.
 
In comparison, investing in an active fund should mean seeking better than average returns. As active managers, we invest in our highest-conviction ideas, irrespective of the benchmark, to construct our portfolios. We believe that taking this risk is the only way to deliver great performance.

The herd mentality

One of the big drawbacks of passive investing is that you risk following the herd. In recent times we have seen significant money flow through passive vehicles into parts of the market that have already done really well, in particular the S&P 500. Clearly, there are risks to this approach of following past performance and if left unchecked it could even create a bubble.
 
For active investors this herd mentality can bring opportunity, and this will become more pronounced if passive funds continue to grow in popularity and dominate a market’s direction for prolonged periods. As active managers we do not have to follow the consensus and can look elsewhere for the opportunities that will set us apart.

Stock selection versus asset allocation

The biggest difference between passive and active investing is that a passive strategy invests at asset allocation level, while an active strategy also makes decisions about which individual stocks to invest in.
 
Active management and its bottom-up stock selection process, means the strength of each business can be determined through fundamental analysis and research, rather than just focusing on its market price and the sector or asset class it sits in. Skilled active management uses this research to find companies with key quality characteristics that should be able to generate consistent and sustainable returns.
 
As an example, we focus primarily on quality stocks that offer:

  • Strong or dominant market positions and sustainable competitive forces that are difficult to replicate
  • Disciplined capital allocation and the ability to achieve high and sustained returns on capital
  • A strong balance sheet
  • Significant free cash flow that can be returned to shareholders
  • Low capital investment requirements to sustain their businesses

While there are passive strategies that invest in quality stocks such as these, they can’t do so at a granular level, and tend to focus on large, well-established businesses. Passive strategies give little credence to the underlying strength of a particular business, so its intrinsic value can be under (or over)-appreciated.

Conclusion

You could argue that active managers, like ourselves, should be concerned about the dramatic rise in passive investing. Far from it.  With active management, the trick is to avoid being sucked in by the story and just following the herd. Right now, there seems to be an investor trend towards passives and it is in times like these that an active manager has every opportunity to add value.
 
We hope that this article has provided you with some food for thought and if you have any queries about how Sanlam can help you, help your clients, and provide you with suitable investment solutions, then please contact your regional sales manager, details of which can be found by clicking here.

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