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Majority of active equity managers ‘face extinction’

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Active fund managers in the UK who routinely fail to beat their benchmarks face extinction according to the head of equity manager research at the investment consultancy Redington.

Nick Samuels says smart beta and enhanced index tracking strategies are placing active  equity managers under greater scrutiny than ever before. According to data from S&P, over three quarters of actively managed UK equity funds have underperformed their benchmark over the past decade, placing large question marks over the justification of their larger fees compared to index tracker funds, more commonly called passive funds.

“It is curious how resilient active equity managers have been in the face of seemingly damning statistics,” says Samuels. “This money being left with underperforming managers can largely be blamed on investor inertia.”

Indeed while assets have been rising in the UK, Samuels says we have not seen the same passive revolution as has taken place in the US. Meanwhile over the last decade, global assets under management in exchange traded funds (ETFs) have soared to $3trn.

In the UK, according to the Investment Association, 76% of assets under management are in active funds, 20% lie in traditional benchmarks via passive vehicles, while only 3% are in enhanced index or smart beta funds.

Will smart beta managers replace active equity managers?

Samuels says that smart beta strategies offer cheap, simple exposure to factors such as value, momentum, quality and low volatility, in an attempt to improve on market-cap weighted benchmarks.

“These systematic, factor tilted strategies now mirror what the majority of active equity managers, either deliberately or not, employ to generate alpha,” he says.

“The advantage of this development for fund selectors, is that they can now place active fund returns in a much better context. Under this lens, comparing a fund manager to the relevant smart beta strategy, the return profile of most active equity fund managers is likely to be diminished.   The debate must now be whether active managers are replaced by these systematic factor based funds.”

The bottom line, says Samuels, is that active equity fund managers, with higher charges, should be able to beat the traditional market cap benchmark and the relevant smart beta strategy. If they can’t he asks what is the point in hiring them?

Is there a place for active equity managers at all?

As the competition has increased, Samuels says we have seen the evolution of the ‘true alpha’ manager. This, he describes, is a fundamental manager who understands the factors and the anomalies they are exploiting and has a process that can offer something much more than smart beta.

“A ‘true alpha’ fundamental manager can offer a differentiated forward-looking approach that is still rooted in an empirically backed style, but allows for the creation of higher conviction, high active-share portfolios of their 30-50 best ideas,” he says. “Smart beta approaches cannot build concentrated portfolios; their reliance on historical data means they need to diversify away the probable errors created, often producing portfolios containing 1000s of stocks.”

Samuels says while fundamental managers come at an increased cost versus smart beta, they should be evaluated in the context of the potential superior excess return that their forward-looking, higher-conviction offering can add.

“Institutional investors, in particular, may find that the marginal extra cost is outweighed by the potential for true alpha,” he says. “A smart beta strategy may be more appropriate for the cost-conscious investor or areas where a superior active, fundamental alternative is not available.”

With the onset of smart beta Samuels argues the industry no longer needs as many active equity managers or researchers to find them.

“True alpha is rare,” he says. “We are able to screen out the vast majority of active strategies using this mind-set. If investors are paying active management fees, they should check that the managers they are using offer more than the systematic, cheaper alternative. It is time to focus on managers that are capable of delivering returns worth paying for and those that are not, will face extinction.”