Skill Matters in Active vs. Passive Debate

RidgeWorth’s research finds financial advisers don’t always consider how the individual skills of fund managers can impact investment returns for their clients—relying instead on more general fund characteristics to select investment products. While it’s clearly important to consider the merits of a fund’s general investment strategy, RidgeWorth contends that financial advisers can add to their own value proposition by identifying top fund managers and directing client assets to the active products they manage.

Understanding the role that individual manager skills play in fund performance can also better inform advisers’ decisions about pursuing active versus passive investments, the firm says. The white paper, “Large Cap Value Indexing Myth-Conceptions: Re-examining the Active versus Passive Management Debate,” suggests selecting a skilled active manager will add substantial value to portfolio returns over time—enough to make well-managed active strategies preferable to cheaper, index-based mutual funds and exchange traded funds (ETFs).

“Conventional wisdom often holds that the ‘average’ active manager has trouble consistently beating broad market benchmarks,” explains Mills Riddick, CIO of Ceredex Value Advisors and senior equity portfolio manager for the RidgeWorth Large Cap Value Equity strategy. “However, an effective large cap fund manager has the potential to outperform benchmarks, and to do so by a significant amount.”

Riddick observes that active managers do not need to outperform their respective benchmarks in every period to deliver stronger overall long-term performance. Rather, it is the frequency of higher returns through evolving market cycles that matters most in assessing active managers, he says.

The paper makes the argument that a skilled active manager can also provide valuable protection on the downside—protection not typically available in passive index products. So while skilled active management over the long term will drain more from net returns in fees and expenses, it should also reduce the risk of major loss in volatile periods. The important calculation, then, becomes whether the long-term expense of active management is greater or less than the protection that’s gained when markets go down.

Research compiled for the paper shows the industry is at something of a crossroads in active versus passive management. Between 2009 and 2013, nearly $37 billion flowed out of actively managed large cap value investments, while some $49 billion moved into large cap value ETFs and other indexed portfolios. The trend of moving money away from active funds slowed substantially in 2013, though, and on RidgeWorth’s analysis, could turn either way in 2014.

When choosing an active manager, the paper suggests an adviser should screen for manager tenure, performance consistency and a reasonable expense ratio. RidgeWorth also suggests investors should consider the opportunity costs associated with an indexed product, especially one is used in an important core portfolio allocation such as large cap value. When examining cost efficiency, a small savings in fund expenses may not be the best outcome if a higher-priced option delivers more than that savings provides in added return.

In assessing Morningstar’s universe of 310 actively managed large cap value funds, RidgeWorth identifies 61 funds, or about 24% of the large cap active universe, as being run by “top-performing managers.” The size of outperformance in this group is substantial, RidgeWorth says. On average, these managers delivered 5.73% more in return than the index across all rolling three-year periods and 13.74% more across all rolling five-year periods. This higher five-year return translates into an additional $1,374 in portfolio value for an initial $10,000 investment, which will likely be considered a high cost to pay for the ease of buying an index product.

The paper notes a number of useful criteria in addition to performance and information ratio that this top-performing group generally had in common:

• Average portfolio manager tenure was 8.19 years, 31% longer than the average 6.25  years for the funds evaluated and 42% longer than the 5.79 years for the entire large cap value category;
• Investment style was generally more consistent as measured by variance tracked by Morningstar’s Style Box analysis; and
• Average fund expenses of 0.95% were notably lower than the 1.03% expenses of the evaluated funds.

To access this white paper, visit www.ridgeworth.com/news-insights/ridgeworth-research.