| Total return to end Feb-2017 | ||||||||
| Inv Tsts | ETFs | Inv Tsts | ETFs | Inv Tsts | ETFs | Inv Tsts | ETFs | |
| Global Sector | 1yr | 1yr | 3yr | 3yr | 5yr | 5yr | 10yr | 10yr |
| Equity | 27.4% | 32.3% | 38.9% | 36.7% | 70.7% | 61.7% | 99.8% | 65.4% |
| Aggressive | 21.2% | 32.3% | 38.3% | 36.7% | 64.0% | 61.7% | 79.6% | 65.4% |
| Miscellaneous | 14.6% | 8.6% | 35.7% | 55.7% | 40.1% | 39.5% | 49.2% | - |
| Fixed Income | 16.2% | 14.2% | 26.3% | 22.2% | 60.2% | 25.2% | 83.1% | 92.4% |
Sources: Morningstar, Fund Consultants
But for those closely following developments in finance literature, the victory for investment trusts may actually not come as too much of a shock. Over the past few decades significant evidence has been building that active managers can and do outperform, and the structure of investment trusts – locked-in capital, independent boards and long-term mandates – makes them particularly well suited to foster such outperformance.
The totem for those subscribing to the view that active management does not work is a paper by Mark Carhart published just over 20 years ago. It concluded that data did “not support the existence of skilled or informed mutual fund portfolio managers”.
In September this year, a paper titled 'Challenging Conventional Wisdom on Active Management' was published by finance professors from the Universities of Notre Dame, Dayton and Arkansas reviewing the wide range of literature published since Carhart’s seminal piece. The review finds: “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.”
Building trust
The authors of the paper point out that part of the shift in favour of active management may come down to the fact that management fees and transaction costs have both been falling. For a long time, and especially prior to regulatory curbs on open-ended fund commissions, lower costs have been an advantage boasted by investment trusts compared with their open-ended counterparts.
Another noteworthy feature of trusts is that they raise money by issuing shares. This can be used to lock in funds for the long term – and, just as importantly, to lock out new funds. Academic findings cited in the ‘Challenging Conventional Wisdom’ paper suggest controlling fund flows is a big advantage for active managers. Indeed, some academics argue “reverse survivorship bias” exists in the data used to analyse active managers because funds that have started out with an ‘unlucky’ run experience outflows and are closed before they get into their stride. More pertinently, research has found that investments made by open-ended funds to deploy inflows tend to weigh on performance.
The reassurance of having locked-in capital may also mean it’s more likely that managers pursue distinct, disciplined and patient investment approaches. Academics have found evidence that each of these characteristics help determine outperformance. High active share – the amount a portfolio differs from a relevant benchmark – tends to also to be associated with outperformance, as does the difference between actual portfolio weightings and the weightings the portfolio would have based solely on the market capitalisation of a holding.
Another read-across for investment trusts from the academic literature is that the boards of trusts should be able to play an important role in determining outperformance by replacing struggling managers while retaining and incentivising successful ones. Researchers have found that after a manager change the risk-adjusted performance of a fund improves by an average of 2 per cent a year. Meanwhile, a relationship has been found between performance and incentives based on a range of measurable factors, including: manager ownership; performance incentive fees; and managers being given a dual hedge-fund mandate to aid retention.
Hard to believe?
Despite the mounting evidence that active management should – at the very least – not be written off, the message is a hard sell at the moment. Fund Consultants points to research from Hartford Funds from late 2016 that found long and persistent cycles of outperformance by both passive and active. While Hartford Funds no noteworthy long-term winner, passive currently has the 'cyclical' upper hand.
A paper from quant firm AQR published in May, which found strong evidence of long-term outperformance by active managers over the past 20 years added some more substance to the view that market conditions currently favour passive. AQR used the example of US large-cap classified funds where it identified three common off-benchmark portfolio “tilts” that have helped explain long-term outperformance but have led to underperformance in the mega-cap-led bull market of recent years. The tilts are towards small-caps, non-US stocks and cash.
Meanwhile, for those fed up with active managers and tempted to go passive, a recent paper from another quant firm, Research Affiliates, titled 'The Biggest Failure in Investment Management', contains noteworthy pause for thought. While it found some evidence for minor underperformance by active managers (about 0.3 percentage points annually), its research revealed that the far bigger issue for investors was poorly timed switching decisions, which it calculated cost investors in large-cap US funds almost 2 percentage points a year. As the report says, “what skilled active management giveth, poor client timing taketh away”.
