Pension plan sponsors continue to debate the merits of active management versus the efficiency of passive management. The answer of which strategy to use is, of course, “it depends,” but a few observations may be of interest.
Over the last 10 years, the median manager in virtually all major asset classes (Canadian equities, U.S. equities large cap and small cap, international equities and fixed income) outperformed their benchmarks. Of course the relative value added varies significantly by mandate—ranging from 10 basis points for Canadian fixed income to 300 basis points for U.S. equities small cap. But, as many will note, these results include the benefits of survivor bias.
After fees, the results are less impressive, with some asset classes (fixed income, U.S. large cap, and even international equities) virtually breaking even with others, netting additional returns of up to 200 basis points. Taking fees into account certainly makes the story less compelling. After allowing for even the modest fees paid by large institutional investors (fees of 30 to 40 basis points for Canadian equities, 50 to 60 basis points for U.S. equities large cap, 80 to 100 basis points for U.S. equities small cap and international equities) outperformance is less certain. These are difficult hurdles to overcome, given that fees are guaranteed whereas performance is not (absent performance based fee structures).
Luck versus skill
One of the arguments in favour of active management is that active managers protect a plan sponsor’s portfolio during periods of market turbulence or uncertainty. This is particularly relevant for fixed income portfolios that are meant to be defensive.
During the 2008 financial crisis, the median fixed income manager underperformed significantly—by more than 200 basis points during 2008—but then the median manager bounced back smartly in 2009 with outperformance of 300 basis points. For equity managers there was no discernible trend, with the median manager tracking fairly closely to benchmarks during this period.
Past performance is no indication of future performance, but when one is faced with over a thousand potential managers in the mandate space being considered, a plan sponsor can’t help but take a peak at past history. Some interesting metrics to look for are:
- extended success in long term performance over one or more market cycles;
- a consistent history of adding value over three year moving average periods; or
- a pattern of modest incremental returns over multiple periods (as opposed to the occasional lucky home run).
The plan sponsor is still left with the challenge of determining whether the outperformance is due to skill and not luck. If one makes the heroic assumption that managers who underperform over the long term are merely unlucky (and not extremely unskillful) then symmetry would suggest that an equal number of outperforming managers are merely lucky.
Depending on the asset class, this suggests that a small portion of managers are actually delivering these outstanding results due to skill. Fortunately every plan sponsor believes that they are able to find these gems!
More benefits to come
Many managers have suggested that we may be entitled to expect more benefits from active management in the coming period. The analytical defense for this statement is that we may be entering into a period of lower correlation between individual stocks and the indexes, and that active managers have generally performed better during these periods. However, just as it is difficult to predict performance, it’s also difficult to predict correlations.
Defending the use of active managers will also be more challenging under the new valuation standards being promulgated. If pension plan sponsors are no longer allowed to take credit in advance for the benefit of active management they will have to be more patient to derive the benefits. At least sponsors will not have to absorb the upfront cost of the higher fees in their valuation basis and so will merely have to wait for the story to unfold).
In looking at industry surveys, there is no particular trend towards or away from active management. Retail investors appear to be flocking to exchange traded funds, but given their cost structure these are hardly a practical solution for institutional investors. And if one surrenders the potential “alpha” from active management, then the only magic bullets left are the traditional “beta” from the volatile and uncertain equity risk premium and the risk-based additional return available from illiquid alternative investments.
If the objective is to meet the funding targets, then plan sponsors need to accept whichever portfolio risks hold the greatest promise—and as many of them as practical.