Using an ‘active investing triad’ for outperforming pension returns

While active managers outperform in some situations and not in others, when using active management, what characteristics can pension plans look for to stay on the outperforming side of the equation?

Using an “active investing triad” — be patient, be different and be aligned — can help find managers that outperform, said Douglas Schein, managing director and portfolio manager at Kingwest & Co., speaking at the 2018 Defined Benefit Investment Forum in Toronto on Dec. 10.

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It’s important to find an investment manager that differentiates itself because they can’t outperform if they look like the benchmark, he said. “Being different matters when you’re trying to get the most out of an asset class. If you hold the same things as your benchmarks, it’s very difficult to outperform.”

This can also be measured by looking at “active share,” or the percentage difference between what’s held in a fund and the benchmark it’s up against, said Schein, noting the higher the active share, the higher the difference. But different doesn’t always mean better, he added. Investors can be different on the wrong side as well.

“So in order to get the benefits of active share, you need to pair it with something,” he said. “I think pairing it with being patient is what the data suggests.”

Schein cited a study by academics Martijn Cremers and Ankur Pareek that looked at three decades of data on active share holdings, allowing investors to compare low- and high-turnover investments, as well as investments with holding periods longer than two years. The study found high turnover took away many of active share’s benefits, and the different, patient cohort created long-term excess returns, he said.

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Plan sponsors are establishing relationships for the long term, so it’s important to ensure a manager will stay different and patient, said Schein, noting one of the best ways is through alignment. “Misaligned managers can occur for lots of reasons. Funds are focused on AUM growth, managers feel career risk to get that short-term performance higher and it drives up agency costs.”

Schein also cited data from Morningstar Inc., which looked at a decade of ratings that divided managers with significant personal investment in their funds and those without. It found those with significant ownership have higher ratings and they maintain them through the course of a decade, he said.

In addition to looking for managers that are patient, different and aligned, plan sponsors can also flip this on its head and look to exclude managers without these characteristics, said Schein. “Consensus holding, restless trading, misaligned managers — at a minimum, those are a set of characteristics you want to avoid.”

Read more articles from the 2018 Defined Benefit Investment Forum