How to pick the right active manager

Volatility has ripped through the equity markets due to concerns surrounding slowing growth in China, a Fed shifting from hawk to dove, the Brexit vote, a turbulent U.S. election cycle and a surprise win by Donald Trump. For any adviser trying to evaluate strategies and build diversified portfolios for clients, that bumpy ride can create opportunity by choosing active managers who know how to leverage volatility. The key for advisers is knowing how to pick the right active manager.

We know that if we invest in a fund that simply follows the benchmark index, we will get nothing more than that benchmark performance, less the fees. That’s why it’s critical to find active strategies that complement the passive ones. What characteristics in an active manager should you be looking for?

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Just as all passive strategies differ, not all active managers are the same. That is why the relatively new metric of Active Share is helpful in measuring the proportion of a fund’s portfolio holdings that are different than its relevant benchmark. An independent third-party measure originally developed in academia, Active Share is not a performance or skill measurement — it’s a yardstick for those hunting funds with alpha-generating potential. But it does not work in isolation. It is the first step in a fund selection process that should also consider a variety of other factors to determine the quality of active management. Here’s what else matters: skill, conviction, opportunity, patience, and expenses, or SCOPE.

It was Martijn Cremers, a University of Notre Dame finance professor, who introduced this concept based on his research into the elements necessary for successful active management. In his research, “Active Share and the Three Requirements for Active Managers,” Mr. Cremers determined that when these characteristics are present, mutual funds significantly outperform their counterparts. For advisers who want to create sustained wealth for their clients, it’s important to know how to evaluate fund strategies to determine whether managers embody skill, conviction, opportunity and patience.

First, the manager should be skilled and have consistently demonstrated an ability to pick stocks.

But, that’s not all that matters. Next, skilled managers typically have conviction in their ideas. Conviction, a crucial part of this analysis, addresses the central issue of whether the manager’s best ideas are included in a concentrated portfolio of stocks. It means, first and foremost, that the manager believes in the companies in which he is invested. Conviction implies that a manager is willing to maintain discipline and adhere to the stated investment style or objective, avoiding any style drift. They must also avoid the temptation to abandon their approach just when it’s needed most. Advisers can measure conviction by the number of holdings, as well as the manager’s concentration in his top holdings. A more concentrated manager will aim for 30 to 40 companies, for example, and not spread risk out over 150 to 200 stocks. The idea is they truly believe in the companies in which they’re invested.

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Advisers should also assess how a manager’s opportunity set may be limited, steering away from those with planned constraints associated with tracking error, for example. Patience is believing in the companies in your portfolio, and not buying and selling when the stock price moves. Advisers should consider how long managers are willing to hold on to their picks and the average holding period of their stocks. Put more simply, advisers should look for managers that don’t trade stocks, but buy companies.

Lastly, with expenses, advisers need to understand how much they’re paying for active exposure. Evaluating the active fee needs to consider the extent of benchmark overlap. Using the SCOPE approach provides advisers with a framework for choosing active managers who will ultimately provide end investors with products that will meet their needs.

So, while fund returns of previous years capture performance history, they can often be arbitrary markers that fail to consider the fund’s strategy and the market environment. It is folly to rely on performance in isolation as the predominant indicator of success because it lacks critical context. Instead of asking whether the fund performed well during shorter time periods, the more meaningful question is, was the investor able to grow his or her wealth over the long-term, during different market environments with funds that exhibit all of the SCOPE characteristics?

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If one is seeking active management, it’s important to select truly active funds. As advisers build diversified portfolios, they need to consider active strategies that complement passive approaches. When evaluating active managers to meet client goals, it is critical for advisers to understand key factors that make them different.

Steve Graziano is president of Touchstone Investments, a mutual fund company committed to providing investors with access to institutional asset managers who act in a sub-advisory capacity.