Independent Thinking^®

The Case for Active Investing

Eighty-four percent of portfolio managers underperform their benchmarks after five years, according to Standard & Poor’s. It seems like a damning statistic – and it can call into question the role of active managers in the first place. After all, the goal of active management is generally to beat the market, although we consider additional factors. So, what does it take? And why do so many managers fall short?
 
Let’s start with the concept of active share. That’s the percentage of holdings in a portfolio that differ from a stated benchmark. A portfolio with holdings and position sizes that match a benchmark, such as the S&P 500 or the MSCI ACWI ex-U.S. index, will have an active share of zero. Passive index funds, which represent the biggest and, for years, fastest-growing segment of the mutual fund market, have zero active share. They won’t underperform their benchmark, but they will never outperform it either.
 
At the other extreme is a portfolio that holds none of the same securities, resulting in an active share of one. In 2009, two Yale professors established that an active portfolio share of up to 20% really should be considered a passive fund; between 20% and 60% is what they described as “closet indexing.” More than 60% makes for a genuinely active fund.¹
 
One of those professors, J. Martijn Cremers, went on to define the three pillars of successful active management: skill, patience, and differentiation, each of which are related to active share.² Skill is the first, in determining which investments can perform better than the benchmarks. While active share is not directly related to a manager’s stock-picking talent, a manager with a lower active share is limited in the ability to potentially discover undervalued investments. For a manager with demonstrated stock-picking ability, higher active share can play a significant role in outperformance, net of fees.
 
Among high active share funds, only those with long holding durations, the second pillar, outperform. Within the quintile of managers with the highest active share, Cremers found that from 1990 to 2015, managers with the longest holding period duration – in other words, the lowest portfolio turnover – outperformed the bottom 60% of managers ranked by duration by about 80% on a net cumulative basis. Managers in the second highest quintile of duration outperformed the same bottom 60% by about 25% on a net cumulative basis.³
 
The final pillar of active management relates to differentiation, or the opportunity a portfolio manager has to deviate from the benchmark. A manager who is unconstrained from benchmark holdings or other limiting determinants of portfolio construction has the most flexibility and a more likely chance to outperform.⁴
 
So where do we fit in? In domestic equities, the largest of our range of asset classes, our concentrated core equity strategy has a relatively high active share: 71% versus its benchmark, the S&P 500 Index, as of the end of the first quarter of 2023. It’s also worth noting that our core equity strategy has a low turnover rate of 12%, as of July 12, 2023; equity mutual funds with turnover between 20%-30% are considered low turnover by Morningstar.⁵ We take the same approach to fixed income and look for similar characteristics in our external international, credit, and illiquid managers.
 
We are proud of our performance. But for us, that’s only part of the story. As managers investing on behalf of families, foundations, and endowments, we measure our performance by our success in meeting their financial goals, as well as against our benchmarks. That means focusing on risk-, fee-, and tax-adjusted results – or what we call “real results,” across all our asset classes. That’s what really matters.
 
For further information on our investment approach and performance data, please contact your Evercore Wealth Management team.

 
Michael Kirkbride is a Partner and Portfolio Manager at Evercore Wealth Management. He can be contacted at [email protected].
 
Joe McManus is a Vice President and Portfolio Manager at Evercore Wealth Management. He can be contacted at [email protected].

¹J. Martijn Cremers and Antti Petajisto 2009, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=891719
²Cremers 2016, University of Notre Dame
³ Ibid. Findings based on ~1,000 funds in the main sample set.
⁴ Ibid. Findings based on ~1,000 funds in the main sample set. Outperformance was observed for managers with highest quintile active share and lowest levels of turnover. ~ 15% on a cumulative basis from 1990-2015.
⁵ Morningstar 2022
 
EWM manages its client portfolios according to each client’s specific investment needs and circumstances. Performance returns within actual client accounts may differ from the EWM Core Equity Strategy due to portfolio management customization, timing of transactions, tax considerations, and other factors. The S&P 500 is the core equity strategy’s benchmark. You cannot invest directly in the S&P 500 index. The S&P 500 is a market-capitalization weighted index that includes the 500 most widely held companies chosen with respect to market size, liquidity, and industry. The EWM Core Equity Strategy holdings will differ from the securities that comprise the index. Unlike the S&P 500 Index, EWM may invest in both U.S. and non-U.S. equities and ETFs. Past performance is no guarantee of future results. All investments involve risk, including loss of principal.

Independent Thinking Panel Series:

First Half of 2023 Recap
Bank Shake-Up: What Does It Mean for Private Capital Investors?
 
The global banking crisis put depositors, investors, and regulators on alert, in a period of already heightened market/economic uncertainty. Evercore Wealth Management Partner and Portfolio Manager Stephanie Hackett led a discussion on this changing credit landscape with Frank Rotman, QED Investors Co-Founder, Partner and CIO, and David Golub, President of Golub Capital.
 
Contact your advisor for replay details.