It is a great time to be an active manager because of the enormous opportunities in the market, but the rise of passive strategies means that staying competitive has become increasingly difficult, according to Monks Investment Trust manager Charles Plowden. 
Active managers have come under increasing pressure as the rise of cheaper passive strategies has prompted many investors to consider what they are paying for.
The introduction of EU regulation MIFID II – which will see research costs unbundled from the ongoing charges figure – and the latest study of the asset management industry by the UK regulator – the FCA – have helped heap pressure on active managers.
“Passive funds continue to gain at the expense of active managers,” he said. “Some asset managers appear to be just giving up and a resorting to scale through amalgamation and cost-cutting to keep going, becoming multi-asset providers and distribution companies rather than active investment managers.
“On the other hand, this is a time of enormous and increasing opportunity for active managers; a time when independent thought and a long-term outlook can literally offer unparalleled returns.
“I believe the scope to add value over and above an index is as great, if not greater today than [at] any time in my 30-something year career.”
He said this is because investors have “diametrically opposed visions” of where markets are and what the future holds.
Indeed, while some investors have called the top of the US equities and global bond markets, both asset classes have continued to surprise to the upside.
Indeed, over 10 years the S&P 500 has rocketed 220.74 per cent while the Bloomberg Barclays Global Aggregates bond index is up by 104.02 per cent.
Performance of indices over 10yrs
rce: FE Analytics
“It is a fundamentally divergent reading of the present opportunities and challenges and it may not surprise anybody but we are determinately in the optimistic camp,” Plowden said.
“We are not here to depress you on the foolishness and incredulity of others but rather to fill you with hope based on the range of compelling investment opportunities we can see before us.”
While there are pressures from the regulatory side, the manager added that these, while deeply annoying and frustrating, will not prove fatal for the industry.
“The impact of passive is undeniably greater and more of a challenge and for all that we have been pointing out some of the disadvantages of passive investing, we do accept that it is not going away. “So rather than just moaning about the growth of passive we have been aiming to address it,” he added.
Many investors in passive strategies explain that the lower fees associated with the products are a big positive, but Plowden noted that returns are more important for investors.
“Lowering fees is the most obvious response to the rise of low-cost passives but to us it is all about investment performance after fees. The return is much more important than the cost of the return,” he said.
After fees, there are many investment trust sectors that struggle to outperform with both the US and global regions particularly wide, as the below chart shows.
Performance of indices over 10yrs
rce: FE Analytics
So how do investors go about choosing the top fund managers from the average? Plowden said there are four main areas to consider.
The first is how active a fund is and whether they are trying to be different to the benchmark as it is difficult to outperform if they are offering a similar product.
“We all know – not least because the FCA has told us – that the average active manager will underperform but the average tells us nothing of course about the above average and whether there is a consistency in the outperformers or indeed how to spot them in advance,” Plowden said.
“There are too many managers claiming to be active but not – these are the closet indexers or closet trackers who are again easy to spot.”
He said investors can do this by looking at the active share of a fund, as this should give a good indication of whether it is ‘hugging the benchmark’.
“Active share is a very simple number that should identify closet indexers and allow you to remove them from your consideration,” he said.
The other characteristic to avoid are managers that are traders rather than investors; this can be done by looking at the annual portfolio turnover.
“There are many managers who claim to be investors but are in fact traders and trading is costly and speculative – it is by definition a ‘zero sum game’,” the manager said.
Lastly are the many active managers who overcharge their clients – those who take too large a proportion of the gains for themselves.
“Active management is not costless but there is a very wide range, so seek to move towards a lower charging fund and manager rather than a higher charging fund – avoid overpaying,” Plowden added.
“I am not here to defend the industry in aggregate, there is possibly a majority of active managers that don’t serve their investors well but above are three simple things to find those that are most likely to succeed.”
The evidence for this and why active share, time frame, and costs matter is summarised in the chart below, which is based on research by academics Martijn Cremers, Antii Petajisto, and Ankur Pareek.
Their studies based on the US market found the average fund underperformed by around 0.4 percentage points per annum after fees: not far from the typical difference between an active and a passive fee.
“That is very consistent with the recent FCA review. Before fees, the FCA have said, there is little to distinguish passive from active, but active managers charge an active fee and therefore underperform,” Plowden noted.
“If you then strip down the total universe and just look at the 20 per cent of managers with the highest active share – i.e. the most different from the benchmark – they have added 1.1 per cent per annum on average.”
This means that the top fifth of managers by active fee have returned on average 1.5 per cent more than the overall average active manager.
“If you take the 20 per cent of the most active managers and take the 20 per cent of those that have the longest time period – so the lowest level of portfolio turnover – suddenly you see that the lowest fifth are adding 2.3 per cent per annum after fees,” the manager said.
This means that the qualifying four per cent – the top 20 per cent for turnover of the top 20 per cent for active share – are offering a return of around 2.8 percentage points per year on average more than the average active fund.
Plowden said: “I think this is a roadmap that should stand the test of time and does of course draw attention to scale of fees which many clients have [been] charged.
“I know there are not too many managers still trying to charge 2/20 [a traditional fee structure among hedge funds] but if you apply that fee to a return of 2.3 per cent you end up with practically zero,” he added. “So, I think it is vitally important to keep fees as low as possible.”
Plowden has run the four FE Crown-rated Monks Investment Trust alongside deputies Malcolm MacColl and FE Alpha Manager Spencer Adair since March 2015.
Since the managers took over, the £1.6bn fund has returned 81.88 per cent 33.31 and 41.25 percentage points ahead of the IT Global sector and FTSE World benchmark respectively.
Performance of fund vs sector and benchmark since manager start
Source: FE Analytics
The fund has been a top quartile performer over this period and is set to return a top quartile return for 2017, the second consecutive year it has done so.
The fund has a clean ongoing charges figure of 0.59 per cent.