- Active managers aim to beat the market in which they invest.
- Active managers can actively manage the risk in a portfolio – avoiding certain securities or market sectors for a variety of reasons.
- Some individual active managers can deliver returns that beat those of the market and some do so with consistency over time, rewarding investors well. However, active managers may underperform their benchmark index.
Active investing is an investment strategy which involves a professional fund manager deliberately choosing to invest in certain securities (such as shares) and avoid others in order to beat the return of the market.
Most active managers will not invest in every security in the market, but some that do invest more in some and less in others compared to their size in the market.
The manager’s portfolio will therefore be different to that of the index for that market. An active share or equity manager in South Africa should have a portfolio that is different to that of the FTSE JSE All Share Index and the manager’s aim will be to deliver better returns than this, or a similar index.
An active equity manager carefully researches which company’s shares in which to invest to select the strongest companies likely to deliver the best returns.
These managers are actively deciding which shares to buy, hold, or sell.
The manager’s insights and research increase the chances, but do not guarantee, that it will earn a return better than that of the market as a whole. It is also possible, however, that the manager could earn a return worse than that of the market.
The return of the market is often referred to as beta. A manager attempting to earn returns that are above those earned by the market is said to be attempting to deliver alpha – the return in excess of the beta.
If you can find a manager who consistently earns a return above the market and compound those returns over many years, your investment will outperform the market return by a large amount.
Strategies used
Active equity managers use different investment strategies. They may:
- Spend a lot of time researching and picking shares or other securities;
- Pick shares that they believe will deliver good returns over a long period because they have a competitive edge or are in an industry or sector that has a competitive advantage;
- Take advantage of short-term price fluctuations to buy securities cheaply in order to sell them when they reach a higher price;
- Aim to avoid investment losses;
- Study market cycles and trends and position their portfolios to benefit from these; or
- They may follow an investment style that they believe will deliver returns above the market.
The power of avoiding loss-making securities
When your investment suffers losses, it needs to earn much higher returns in order to recover to the level it was before the loss. Avoiding losses can therefore help an active manager outperform the market.
For example, assume you invest R100 in a market and the market goes down causing you a 10% loss. You then have R90 and will need to earn an 11% return on the R90 before you will again have a R100.
Risk management
A benefit of using an active investment manager is that their research and careful selection of where to invest can prevent your investment from being exposed to individual shares, sectors of the market or regions that are expensive or likely to perform poorly.
Many managers focus on what is known as downside risk, seeking to avoid investing in securities that are likely to show the biggest losses when the market falls.
They also avoid investing in shares when they are expensive, as it is likely that high prices will come down to more reasonable levels, causing investors a loss.
A manager who does good research should also be able to identify and avoid investing in companies that may be exposed to a corporate, environmental or social disaster.
An active manager can manage the portfolio’s overall exposure to risk. A bond manager, for example, will manage exposure to bonds with a high risk of defaulting, or will manage the term to maturity of the bonds if there is a risk of a change in interest rates.
Active manager performance
There are a number of things you should consider when you choose an active manager. Performance is only one of these things, but it is often given a lot of attention.
Remember, when you consider the performance of an active manager you need to consider:
- The performance relative to a benchmark that ensures your investment grows by more than inflation and meets your investment goals.
- The performance relative to an appropriate benchmark given the mandate the manager has to invest and any restrictions on how it can invest. If the manager is, for example, limiting or capping it’s exposure to certain large shares, comparing its performance to an index in which the shares are not capped is not appropriate.
- If your manager is managing a fund that must comply with investment guidelines in Regulation 28 of the Pension Funds Act, you should not compare its performance to a benchmark that does not have the same restrictions.
The performance over an appropriate period. The manager should be targeting a particular return over a certain period. Performance measured over a shorter period may be below that target.
Investment fees
All managers charge fees to cover the costs of running their investment portfolio or fund.
Active managers generally charge higher fees than managers of index-tracking investments because they have to pay experienced and professional fund managers to decide on where to invest, analysts to do the research to inform their decisions and the professionals who buy and sell the securities they need.
Active fund managers may also charge performance fees, taking a portion (eg one fifth) of the return the portfolio earns above the index.
The total expense ratio measures, among other things, the fees a manager charges. Managers also report a total investment cost that includes the costs of trading shares or other securities in the portfolio. But a good way to check the costs of investment product are to look at the effective annual charge.
Research produced by, among others, fund rating house Morningstar shows that fund fees as measured by total expense ratios are the most proven predictor of future returns. This is because high fees create a higher barrier that a manager must clear before it delivers an after-fee return above the market.
Morningstar says it does not suggest you exclude all funds with high fees, but you should use high fees as an important factor when you consider whether to invest with a manager.
This article was first published onSmartAboutMoney.co.za, an initiative by theAssociation for Savings and Investment South Africa(ASISA).
