THE CASE FOR TRUE ACTIVE MANAGEMENT
from Trust the Leaders Issue 29, Summer 2011
BY JAMES M. FRANCIS, VICE PRESIDENT, MONTAG & CALDWELL, LLC
The last few years have raised concerns about the ability of traditional active managers and, in particular, large cap managers, to generate “alpha” — the excess return of a mutual fund relative to the return of a benchmark asset — for clients’ portfolios. As a result, many investors have shifted toward alternative investment styles.
To mitigate relative risk, other investors have opted for a more passive approach, believing that markets are efficient and that long-only active managers cannot outperform their respective benchmarks, and thus are unable to add alpha while taking on additional risk in the form of higher tracking error.
What is tracking error and why is it important?
Tracking error traditionally has been a measure to determine how closely a manager was able to “track” a desired benchmark. The statistic had become popular as a tool to evaluate active management during the bull market of the 1990s. Because the focus was a fear of not keeping up with the benchmark of the overall market performance (the opportunity cost), looking at tracking error seemed logical.
Once the concept of tracking error became integrated in the investor psyche, the market reached its height and the technology bubble began to deflate. Investors using a low tracking error approach experienced large losses, locking in negative returns in sectors that became overvalued. While their relative risk in the form of lower tracking error may have been low, their absolute risk was substantial.
Managers have struggled to outperform market-cap weighted benchmarks when those benchmarks have been dominated by a few narrow themes. To keep up with the benchmark in these market environments, managers have employed a low tracking error approach that typically participates in only part of the upside, but all of the downside.
What drives the “tracking” mentality?
Some investors yield to short-term performance pressures rather than focusing on long-term goals and, in some cases, the fiduciary responsibility of making money for the beneficiaries of the managed portfolio. Keeping up with the market can overshadow common sense and the focus on the goal of building wealth over time. The attention paid to tracking error forces many active managers to stray from their disciplines in order to stay in the game. Ultimately, this is a losing strategy.
Since it is the goal of an active manager to beat the comparable index, it is practically a requirement that the manager be different from the index in its return pattern. The index is a trend follower, adding stocks in popular sectors while reducing exposure to out- of-favor sectors. Index weightings reveal consensus opinion as to what the “attractive” sectors are and which parts of the market are being neglected.
Indices are not portfolios designed to control risk by allocating capital from overvalued sectors toward undervalued sectors. In fact, an index does just the opposite by adding names to sectors that nare doing well, usually up to the point of collapse. This can result in a much greater exposure than one would logically want in any one sector.
Why active risk can outperform passive risk
Active managers capitalize on pricing inefficiencies by taking positions relative to the benchmark on information unique to the individual company. This approach is not necessarily “riskier.” By focusing on fundamentals such as valuation and avoiding speculative excesses, good managers with an active risk approach often have favorable risk statistics due to their ability to protect in down markets.
For active managers, tracking error has little or no meaning. Since not investing is their default position, these managers have a lot of conviction in fewer names as opposed to others who focus on benchmark risk. Studies have shown that approximately 12 to 18 investments are sufficient for a portfolio to be diversified, so any concerns about concentrated portfolios lacking diversification wand increasing risk can be exaggerated.
In fact, we believe that utilizing more of a passive approach actually increases your risk because you become more benchmark-like with the greater number of stocks in your portfolio. On the contrary, concentrated managers limit their holdings in order to maximize exposure to stocks with the greatest potential without diluting the impact of their best ideas. Overall, investors need to take a longer-term view and realize that even the best managers will have some bad years. There have been and will be periods of underperformance during more narrow markets due to factors such as market speculation and extreme style and size biases.
At Montag & Caldwell, we are dogmatic in our approach to growth investing and, given our rather agnostic philosophy to benchmarks, we naturally take some active risk in our portfolios. However, it is not a question of whether or not we can add value to a passive index return over time, but whether or not our investment methodology can be explained and predicted to our clients’ satisfaction.
Many investors today focus on short-term relative performance. To maintain and grow assets, some asset managers have opted to focus more on their business risk, which is best achieved through a low tracking error approach. However, the mismatch of a long-term investment process and short-term performance pressures has forced many to compromise their approach in order to look more like the benchmark. This performance/evaluation cycle is flawed in that good stock pickers at times can be forced into mediocrity — which is not necessarily in clients’ best interest.
A good fundamental discipline is still appropriate for alpha-seeking portfolios. In an environment without speculation or a narrow theme, a disciplined, active approach should do well — provided that the management team has experience with a time-tested process. These environments present fewer options to outperform, which gives true active managers an advantage when identifying opportunities to add value to their client portfolios.
In September 2010, Montag & Caldwell completed a management buyout in which 28 senior managers acquired the firm from the Paris-based banking conglomerate BNP Paribas and the Belgian government. As a result, Montag & Caldwell is now once again locally owned. Smith, Gambrell & Russell acted as legal advisors to Montag & Caldwell management in the transaction.
Adhering to the premise that a low tracking error is not necessarily the key to long-term wealth building, true active fund managers can add “alpha” while mitigating risk.
The downside and risk of passive management
The financial charts below show that “passive” investors would have participated to their detriment by buying stocks at their highest prices in the November 1980 energy peak, March 2000 technology peak, and October 2006 financial peak.
DISCLOSURES
- The S&P 500 Index is an unmanaged index commonly used as a benchmark to measure U.S. stock market performance and characteristics.
- The Russell 1000 Growth Index is an unmanaged index commonly used as a benchmark to measure growth manager performance and characteristics.
- The Russell 1000 Value Index is an unmanaged index commonly used as a benchmark to measure value manager performance and characteristics.
- Montag & Caldwell is an SEC registered investment adviser that provides investment management services for assets in the following domestic strategies — large cap growth equity, mid cap growth equity, fixed income, and multi-strategy (e.g., balanced) — primarily for, but not limited to, U.S.-domiciled clients. Effective September 24, 2010, Montag & Caldwell’s employees now own 100% of the Firm.
- Montag & Caldwell claims compliance with the Global Investment Performance Standards (GIPS®). To receive a complete list and description of Montag & Caldwell’s composites and/or a presentation that adheres to the GIPS® standards, please call 800-458-5868.
