Despite significant inflows towards index funds over the past few years, few would deny there’s still a place for an actively-managed strategy – but how do you choose the right one for your client?
Ideally, an actively-managed portfolio will contain securities selected via a rigorous due diligence process and a particular investment style and philosophy aimed at delivering above-market returns over rolling multi-year periods. Long used alongside index products, active managers have come under more intense scrutiny recently due to concerns about fees, performance and the often opaque nature of their strategies.
Of course, no two managers are the same, which is why there are a few key issues to consider when implementing an active strategy in your client’s portfolio:
Performance
While all active managers will note that “past performance is not an indicator of future performance,” it’s worth considering how a particular strategy has performed over a specific period – say, five years on an annualised basis – compared to both its peers and the broader market. It’s entirely possible for a particular manager to experience periods of lower performance over certain periods, but if the strategy has performed well overall, this is a good starting point.
The flipside of this is risk. It may not always be the best option to pick the star performer in a particular asset class, because this manager may have taken on an unnecessary level of risk in order to achieve those returns, potentially exposing its investors to sharp downturns in particular periods.
The common industry benchmark to determine risk-adjusted performance is the Sharpe ratio – most ratings and research houses will include this number in documentation about a particular fund. It’s worth comparing similar funds’ Sharpe ratios as well as their overall performance, as this will give a clearer picture of the level of risk you’re taking on.
Fees
Of particular concern for many investors is the higher cost generally attached to actively-managed strategies. These can take the form of both management and performance fees, and how costs are determined can vary a lot from manager to manager.
Fees are a critical consideration for investors, because if the balance between performance and cost is off, any extra performance a manager generates can be eroded away – arguably defeating the purpose of investing in an actively-managed fund in the first place.
Diversification
It’s important to consider what an active strategy is actually adding to a client’s portfolio, because if they’re just paying extra fees for a level of performance that closely follows the index a fund is aiming to outperform over multiple periods – “index-hugging,” in other words – it’s likely that fund won’t deliver any diversification benefits to your investment strategy.
Balancing the above two points, you’re looking for a manager that can deliver you three things: a favourable risk-adjusted return, a fee mix that won’t erode that return over the long-term and performance that’s sufficiently distinguished from an underlying index so as to make the investment worthwhile.
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