Practical analysis for investment professionals
11 March 2020

Good vs. Bad Active Fund Management: Three Indicators

Do you ever wonder whether your active fund is worth the management and performance fees you charge? Would passive investments have yielded similar or better outcomes for your clients?

If you haven’t asked yourself these questions, you can be sure your clients have asked themselves. And they will continue to, measuring what you deliver with what they can get from the passive alternatives on an ongoing basis. As well they should.

Given the turbulent global markets, you have to continually convince your clients that as their fund manager you have the skills to navigate them through challenging times, that their money is in safe and wise hands. You can’t leave it up to your firm to make that case for you.

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Your clients should be assessing your fund management style, so you need to be able to show, in both word and deed, that you are doing it right.

After all, the challenge isn’t just from passive investments alone. Despite the many death notices that have been written, active fund management is very much alive and kicking.

According to PWC, by 2025 the overall global assets under management (AUM) are expected to grow by 31% to US $145.4 trillion. Passive investments will make up only 25% of that total. Active investments will continue to dominate with 60% of total AUM.

But investors are growing more risk averse and with its low fees and “buy-the-market” mentality, passive investing has an intuitive appeal over active. So while active’s AUM may be growing, its market share is shrinking. The PWC report projects that by year-end 2020, passive investments will make up 21% of global AUM, up from 17% in 2016. Active will be down to 66% from 71%.

This means that markets are becoming ever more efficient with fewer undervalued/mis-priced securities and thus fewer opportunities for alpha generation.

Nevertheless, to compete with passive and other active managers, you have to show your clients that you are one of the good ones, that you have a good active fund management style.

So what distinguishes active styles? Three key characteristics stand out and the discerning client will be looking to determine that you have them. Be ready to demonstrate that you do.

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1. Low Turnover

What’s your turnover ratio?

Something in the 20%–30% range indicates a buy-and-hold strategy and good style. Nobody wants to see their returns eaten up by management fees and a high turnover ratio may suggest there’s some churning going on. And that’s the last thing you want clients to think.

2. High Conviction

The great value investors don’t buy securities they don’t believe in. And your clients don’t want you to either.

Does your fund have more than 20 highly concentrated positions? Evidence suggests active managers do best when they overweight their high-conviction investments. So if the number of your high-conviction securities is, in fact, on the high side, clients may start to wonder just how deep your convictions actually are.

3. High Tracking Error

And what about tracking error? If yours is too low, it might give the impression that you’re just tracking an index, offering clients passive returns at active prices.

A high tracking error shows you’re actively looking for alpha.

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Both current and potential clients need to be able to assess your style as an active fund manager. They’ll be looking for data. And some key statistics may not be provided in your factsheets or monthly performance reports.

If you want to differentiate yourself in an increasingly competitive marketplace, you have to be ready to give clients what they want. Not only will it help you win their trust, it will demonstrate your value over the competition, both active and passive.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/Carol_Anne


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About the Author(s)
Femina Huddani, CFA

Femina Huddani, CFA, is the vice president of asset management at The National Investor (TNI), based in Abu Dhabi, UAE. She has over 13 years of diverse experience in finance and investments across the US and MENA markets. Prior to joining TNI, Huddani worked in various analyst roles with Citigroup SmithBarney (USA), YieldQuest (USA), Deloitte Consulting (UAE), and Mashreq Capital (UAE). She graduated with a bachelor’s degree from Georgia State University with a dual major in finance and accounting.

5 thoughts on “Good vs. Bad Active Fund Management: Three Indicators”

  1. Many thanks. Very good piece.
    The current market turbulences (understatement!) are likely to have an impact on the ‘buy the market’ mentality you are referring to.
    As for turnover, the ratio is likely to differ depending on the type of funds one is talking about (eg full equities vs multi-assets).
    On a more general note, I would say that performance should not be limited to alpha generation. A well performing actively managed fund is one that meets its objectives as properly disclosed to investors (eg income generation, low volatility, long term appreciation, ESG, etc.).

    High volatility, under-researched stocks, low interest rate environment, etc, offer active managers opportunities to prove their worth.

  2. Nick Deist says:

    “But investors are growing more risk averse and with its low fees and “buy-the-market” mentality, passive investing has an intuitive appeal over active. So while active’s AUM may be growing, its market share is shrinking. The PWC report projects that by year-end 2020, passive investments will make up 21% of global AUM, up from 17% in 2016. Active will be down to 66% from 71%.

    This means that markets are becoming ever more efficient with fewer undervalued/mis-priced securities and thus fewer opportunities for alpha generation.”

    A greater passive share will likely create greater mispricings and more opportunities to generate alpha for active managers. Most indices are market cap weighted, which results in passive allocation based on size (Market cap). It fails to consider the price relative to earnings (or other fundamentals) that drive value.

    The passive mechanism encourages investors to buy expensive stocks in greater magnitudes as market share grows and the opposite when the market share shrinks.

    This could result in buying high and selling Low depending on the underlying fundamentals. So I would not agree that an increasing passive share results in more efficient markets.

    I’d also like to comment on management fees and churn/turnover. The turnover wont impact management fees ( the fee the investor pays the manager to invest their funds) as this depends on AUM. But it will impact trading costs.

    Higher turnover will increase trading costs and reduce return. This reduction in return compounds over time so it’s very important to keep turnover low.

    However, trading costs have fallen significantly and continue to do so this impact on the portfolio is decreasing!

  3. H P Boyle says:

    I am a bit surprised that this got published here. While those three attributes are certainly reasonable for outperforming funds, they can also be just as true for underperforming funds. Bad ideas held in a concentrated book with conviction can carry a fund manager out of the business.

    Where is the data to support the author’s assertions?

    This is more of an article for a site like Medium than something for a site as important as the CFA Institute. Please keep the standards high!

    1. Tong Foo Cheong says:

      I agree with HP Boyle.

      This article is the type that should be in one of the thousands of financial blogs by amateur s0-called investment experts, not on the CFA Institute’s website.

      Is there evidence that 20 – 30% turnover is low turnover? Shouldn’t it be like 5 – 15%? A certain sage from Omaha said that a good investment is one that he will hold forever. So a turnover of 20 – 30% seems at odds with a high-conviction portfolio.

      Students of investments were taught that, statistically, a reasonable number of securities for a diversified portfolio is a minimum of 30. Those with high-conviction (whether client or fund manager) may opt for fewer securities in their portfolios but this is not the whole universe of clients and fund managers. Having more securities does not mean one has lower conviction, it means that one targets a different risk-return objective.

      As for tracking error, a large part of the cause lies in gatekeepers who advise the institutional investors that high tracking error could be a result of style drift. Tracking error is not the end in itself, it is the information ratio.

  4. Theresa Hamacher says:

    Great piece!

    Dave Lafferty at Natixis recently expressed similar ideas in a white paper published by the Active Managers Council, tilted “A More Balanced Narrative: Setting the Record Straight on Active Management” (available at activemanagers dot com).

    For an extensive review of the academic research on drivers of performance, it’s worth looking at the fourth quarter issue of the Financial Analysts Journal. In an article titled “Challenging the Conventional Wisdom on Active Management,” Martijn Cremers, Jon Fulkerson and Tim Riley provide a summary of the literature.

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