The concept of active management has been in Touchstone's DNA since our establishment in 1994. Along the way we continue to focus on ways to successfully incorporate active management as an integral component to meeting investment goals. Please continue reading to find out why Touchstone's Distinctively Active approach is important for financial professionals and investors.
We believe proponents of active management face two critical issues today:
- The assessment of active investment performance focuses on aggregate results across all “active” managers and most managers have not delivered on expectations.1
- Criteria used to evaluate and select individual investment managers comes from studies that aggregate all investment styles together and ignore key concepts associated with delivering better performance.
These issues lead many professionals and investors to a negative conclusion about ALL active management. We believe this is shortsighted. In response, Touchstone has identified a set of core characteristics that allow us to evaluate truly active management. Our approach is Distinctively Active and here, along with accompanying articles in this series, we will share our insights with you.
Active Management Is Alive & Well
Index investing – commonly referred to as passive investing – has seen tremendous growth in the last ten years, from $1.9 trillion of index mutual funds and index ETFs in 2010 to $10 trillion at the end of 2020.2 Despite the rapid rise in passive index investing, assets invested in active strategies have also grown from $8 trillion in 2010 to $14.9 trillion at the end of 2020.3 We believe claims that active management is “dead” are vastly overstated.
Yet the rapid growth of indexing over the past few decades begs an important question:
Why Has This Happened?
First, Touchstone acknowledges that establishing exposure to a “market” based on low cost is completely reasonable to do. With that option in place, investors should naturally ask, “what do active managers provide compared to what I can get for a lower cost?” When it comes to active management, it is easy to find articles that state many active managers have not delivered on their goals.4 Unfortunately, this can drive investor behavior we believe may only intensify their disappointment. Touchstone believes there are several key reasons for this comment.
Inertia
Active mutual funds with the longest histories have amassed large asset bases.5 These funds tend to stay large over time — not because they earn outsized returns, but because of inertia. At the end of 2020, applying Morningstar data and Touchstone analysis, three-quarters of assets invested in “active” large cap and small cap U.S. equity mutual funds were invested in funds that were:
- “Closet-indexers,” where a large portion of holdings overlap with a relevant benchmark,6 and/or;
- Bloated with high assets under management which severely narrows their investment options, and/or;7
- Diluted because the large number of holdings diminishes the impact of their best ideas.8
At Touchstone, we believe that delivering value via true active management requires maintaining the ability to beat the benchmark. That is hard to do with high index overlap, bloated asset bases and over-diversified portfolios.
Performance Chasing
Studies that examine investor behavior show that investors have crowded into funds with recent good performance and exited impulsively from those with recent poor performance.9 Investors have tended to buy a fund near the peak of its relative returns without considering performance beyond the most recent trailing returns or attributes that may impede future performance. Touchstone believes this could be a recipe for poor subsequent performance, too.
This performance chasing was shown in a recent study to be the primary driver of fund selection. The main conclusion of “What Do Mutual Fund Investors Really Care About?” is: “fund flow data are most consistent with investors relying blindly on fund rankings (specifically, Morningstar ratings) and chasing recent returns.” While buying a fund solely based on performance is not limited to active strategies (consider the flows to U.S. large cap index strategies over the past bull market decade), we believe the tendency to chase rearview fund rankings has led to investor disappointment with their subsequent returns.
So Much Noise
Touchstone believes that because financial professionals and investors have been inundated with competing information from so many sources, a fog has descended on discussions regarding active management.10 Wading through the sheer volume of information at hand can lead many financial professionals and investors through a circular loop to inertia.
In addition, without conviction in active management selection criteria, many financial professionals and investors have focused – sometimes entirely – on costs, mistakenly assuming cheaper means better. Typically this emphasis on cost ignores what may be received in return. Interestingly, recent research regarding active management performance suggests that there is little to no correlation between expenses and the performance of the most active strategies.
Conclusion
The factors discussed above led Touchstone to research and create a unique approach with which to identify and evaluate Distinctively Active asset management. An overview of these key characteristics is the subject of an upcoming article in this series.
1 K. J. Martijn Cremers, Jon A. Fulkerson, and Timothy B. Riley, 2018. “Challenging Conventional Wisdom Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds.” Working Paper.
2 2021 Investment Company Factbook: A Review of Trends and Activities in the Investment Company Industry.” Investment Company Institute. May 2021: p. 65 https://www.ici.org/system/files/2021-05/2021_factbook.pdf Accessed on 10 June 2021
3 Ibid.
4 “SPIVA U.S. SCORECARD.” S&P Dow Jones Indices. https://www.spglobal.com/spdji/en/documents/spiva/spiva-us-year-end-2020.pdf Accessed on 10 June 2021.
5 “2021 Investment Company Factbook: A Review of Trends and Activities in the Investment Company Industry.” Investment Company Institute. May 2021: pp. 72-73 https://www.ici.org/system/files/2021-05/2021_factbook.pdf Accessed on 10 June 2021
6 Cremers, Martijn, and Quinn Curtis. “Do Mutual Fund Investors Get What They Pay For? The Legal Consequences of Closet Index Funds.” SSRN. 24 November 2015
7 Jonathan B. Berk and Richard C. Green, 2004. Mutual Fund Flows and Performance in Rational Markets, Journal of Political Economy, vol. 112, no. 6, pp 1269-1295. They argue that a fund manager captures the economic rents from their skill by growing the fund, since fees are generally based on the size of the fund and not on its performance. However, as the fund grows large, it becomes increasingly difficult to generate superior returns. Evidence points to $1 billion as the upper AUM bound for successful stock picking.
8 Cohen, Randy, Christopher Polk, and Bernhard Silli. “Best Ideas.” SSRN. 21 April 2021
9 “2021 Investment Company Factbook: A Review of Trends and Activities in the Investment Company Industry.” Investment Company Institute. May 2021: pp. 72-73 https://www.ici.org/system/files/2021-05/2021_factbook.pdf Accessed on 10 June 2021
10 K. J. Martijin Cremers, Jon A. Fulkerson, and Timothy B. Riley, 2018. Challenging Conventional Wisdom Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds. Working Paper. They concluded: “While the debate between active and passive is not settled and many research challenges remain, we conclude that the current academic literature finds active management more promising for investors than the conventional wisdom claims.”
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