How to Identify Truly Active Managers

In another article in Touchstone’s Distinctively Active Management series we discussed why it is important to have an open mind about active investment management. We also noted that many years of research and experience in active management has led to what we believe is a unique methodology for identifying truly active investment managers. Here is an overview of that.

The Landscape

Some active asset managers reject index investing with gusto, claiming that it destroys price-discovery and even that it is almost blasphemous. But at Touchstone we have a common sense acceptance that:

• Capitalization-weighted indexing may be a reasonable and cost effective option for investors seeking to achieve market exposure to broad groups of companies with similar characteristics.
• The current bull market – and hence trailing investment returns – are dominated by the largest and most growth-oriented companies.

Given this backdrop, we think that effective active management must be differentiated from low-cost index investing strategies. We also think that active strategies should possess other qualities, ones that research suggests are associated with potential benchmark outperformance.

Touchstone’s Distinctively Active Factors 

Touchstone’s Distinctively Active approach for identifying truly active asset managers whose results have the potential to outperform the benchmark is grounded in both quantitative academic research as well as our qualitative practical experience. This understanding is the basis for our “SCOPE” framework which we use to select the managers in our fund lineup.

The factors that make up the "SCOPE" framework are Skill, Conviction, Opportunity, Patience and Expenses. It is important to note Touchstone believes each factor interacts with and impacts the others – no one factor stands alone. That means SCOPE’s components should be considered simultaneously and not in isolation. Let’s take a look at the factors:

Skill

To identify investment skill, Touchstone thinks it is important to move beyond a manager’s most recent 1-, 3-, 5-, and 10-year fund performance periods. Instead we believe it is important to evaluate performance by rolling through the life of a fund, rather than looking at these fixed periods. This is in stark contrast to most fund performance ranking systems. Why would we focus on only four fixed periods when there are dozens or even hundreds more to be considered when evaluating investment asset manager skill?

Additionally, Touchstone also tends to focus on medium- and longer-term periods (e.g., 5-10 years), which capture more diverse market environments. We believe this approach is more aligned with clients’ achieving their long-term financial goals.

The remaining elements of SCOPE are based on academic research which has identified key characteristics associated with the potential to deliver better performance than indexing as well as to help distinguish those perceived active managers that employ index-like strategies.

Conviction

There are many ways to measure conviction, each correlated to skill. Studies indicate that the impact of diversification may wane beyond a couple dozen stocks. Therefore, Touchstone favors skillful managers that differentiate their exposures from benchmarks and concentrate their investments in their highest-conviction ideas.^1,2 Statistics like Active Share® allow us to differentiate individual portfolios from their performance benchmarks. Active Share^® is based on the idea that only investment exposures that are different from an index have potential to contribute to outperformance of that index. Further, recent studies from Harvard and Emory show that the highest-weighted positions in actively managed strategies have delivered outperformance and that high-position overlap with an index as well as ownership of too many positions reduce the inherent value proposition of active management.

Opportunity

Active asset managers need the opportunity to exercise their ability. This requires fewer constraints being applied on the investible universe from factors such as: a) too many assets under management,³  b) too rigid investment constraints managers place on themselves (for various reasons), or c) too narrow an investment bandwidth placed on managers by investors.⁴

Patience

Just as investors should exercise patience and avoid “performance chasing” (see our related article), asset managers too are rewarded for patience. This is measured most easily by lower portfolio turnover ratios. Research by Martijn Cremers, “Patient Capital Outperformance,” examines the relationship between fund performance and the combination of Active Share and Holding Period.⁵ The findings suggest that impatient active strategies – whether index-like or highly active – showed no evidence of producing alpha, while the most active/most patient combination of strategies significantly outperformed passive investing.

Expenses

At Touchstone we believe the discussion of fees tends to be particularly one-sided. A more comprehensive discussion requires an understanding of what those expenses are buying. We believe investors would be better served by reasonable expenses relative to the benefits received. In other words, do investors get what they pay for? Truly active management requires deeper and broader research resources and is thus inherently more expensive than indexing.

We believe that expenses must be reasonable relative to the performance potential of a strategy when compared with indexing. The alpha potential of an index strategy is zero and indeed index funds are verging on zero cost (in some cases they are already there). For active funds, performance is quoted net of fees. Given this, any outperformance by an active fund versus an index by definition justifies its expenses when compared to an index.

In Conclusion

Touchstone’s Distinctively Active approach provides active strategies which have demonstrated success, while maintaining characteristics relevant to the potential to deliver strong future performance. Focusing on these factors can lead to a positive transformation of the active management opportunity set and may improve results.

Periodic articles in the Distinctively Active Management series consider each of the above major characteristics in greater depth. One of our primary goals is to help financial professionals and investors understand greater practical benefits from active management in achieving long-term objectives through our Distinctively Active approach to investing.

¹ Brown, Keith C., Cristian Tiu, and Uzi Yoeli. “The Decision to Concentrate: Active Management, Manager Skill, and Portfolio Size.” SSRN. 7 September 2017  https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3032200 Accessed 10 June 2021
² Cohen, Randy, Christopher Polk, and Bernhard Silli. “Best Ideas.” SSRN. 21 April 2021
³ Brown, Keith C., Cristian Tiu, and Uzi Yoeli. “The Decision to Concentrate: Active Management, Manager Skill, and Portfolio Size.” SSRN. 7 September 2017  
⁴ Cremers, Martijn. “Active Share and the Three Pillars of Active Management: Skill, Conviction and Opportunity.” SSRN. 27 August 2017
⁵ Cremers, Martijn, and Ankur Pareek. “Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently.” SSRN. 1 December 2015