The Market Benchmark Problem

Why has active fund management largely failed to outperform passive management net of fees?

The Market Benchmark Problem

Active fund management has, with some notable exceptions, largely failed to outperform passive management net of fees.  

This has been particularly the case, since the 2008 Crash. The impact of this has been substantial outflows from ‘active’ mandates into passive alternatives. Their growth in AUM arguably represents a major misallocation of resources. The AMps approach, used within the IAM Advisory investment service, provides an intuitively attractive solution to meet the current problems of both active and passive management.

'Active' investment

IAM can show that the opportunity for adding to returns through proper ‘active’ investment is substantial. A few managers, who are consistently performing well and are clearly thinking ‘outside the box’, have successfully captured this opportunity and demonstrate the possibilities inherent in a different investment process.

Academic work suggests that actual underperformance by active managers, net of fees, relative to passive funds continues. Few have asked why this difference is occurring and how it can be addressed.

Market Indices

We contend that the cause of this mismatch reflects the fund management industry’s almost universal obsession with market indices at every level of the investment process. Typically, a static composite index benchmark allocation is used for initial portfolio construction in setting a risk profile and a target return.  The portfolio is then managed around this strategic allocation and the risk around this standard is controlled through tactical ranges.  Managers consider a key risk as being how far they are from the market benchmark. Portfolio performance is then measured against the same standard.  With such a background it is unsurprising that the potential for active management is not being fully accessed. It is illogical and counter-intuitive that we should attempt to drive an ‘active and dynamic’ investment strategy by reference to, and comparison with, a passive static standard and then complain about the result.

The Risks of a Passive Approach

What is less appreciated is that passive strategies also represent substantial and unappreciated risks and costs.

  • The average passive investor has a poor record on the critical decision of timing, entry into and exit from the market
  • Many funds are covering their market exposure, all or in part, through derivatives, particularly at times of market stress. This potential counter-party risk is not and cannot be reflected in the statistics - until there is a failure
  • More complex or specialist passive strategies are still charging fees that can be significant
  • As passive funds become more focused the clients are in effect taking ‘active’ decisions in determining the character and size of underlying specialist allocations. Evidence suggest they are rarely getting these difficult decisions right
  • Serious anomalies are emerging in the passive universes. Positions are predominantly allocated based on market capitalisation. Risks are emerging of large individual companies representing in excess of 10% in an indexed fund. In the event of sustained selling of these funds, the managers will be struggling to place the orders to rebalance in a reasonable time frame and provide contracted liquidity without in turn affecting the pricing. A potentially dangerous feedback loop.
  • Counter-intuitively, the decision of when to hold in an index is arguably a much more complex decision than whether to hold a single stock within a portfolio 
AMps provides a direct solution to these problems that has proven potential for increasing investment returns and a better way to manage and control risk.