There are three key reasons why an active manager can deliver alpha, despite the emerging orthodoxy that passive management is the only way to invest, says Kevin Bernzott of Bernzott Capital Advisors.

Kevin Bernzott is chairman and chief executive of Bernzott Capital Advisors, an independent institutional
money manager in Southern California
serving foundations, endowments, public
and private retirement plans.

In their paper, Luck
Versus Skill in the Cross Section of Mutual Fund Returns, University
of Chicago finance professor Eugene
Fama and Dartmouth
finance professor Kenneth French concluded that 97 per cent of the performance of
active managers is due to chance. In other words, only the top 3 per cent are due to
the manager’s skill.

Given that the odds
are stacked against investors, is it worth the trouble to seek out an active
manager who can outperform? The answer is yes, absolutely. It requires greater
due diligence and a commitment to identifying a consistent outlier, but ultimately
the rewards can be significant for investors.

Finding performance
above the benchmark is even more noteworthy today because so many investors
believe the index is the best they can do. The market share of active managers
continues to shrink, while passively manage funds continue to grow, according to
Boston Consulting Group. As one BCG executive said recently: “The glory
days of stand-alone, active managers focused on outperforming a benchmark are
gone.”

That may be true,
but with less money in active managers, actively managed funds that deliver
alpha will stand out like a neon sign. That’s a differentiator for endowments,
pension funds and advisors with demanding clients or oversight committees.

How much better can it be?

As a proxy, consider
the Bernzott Capital Advisors US Small Cap Value composite, which has beaten
both the Russell 2000 Value Index and the Russell 2500 Value Index, net of
fees, for five- and seven-year periods ending 2Q 2013.

Since inception 18.5 years
ago, the strategy is up an annualized 13.60 per cent net of fees, compared to 10.67 per cent
for the R2000V. When fees are subtracted, index returns are lowered to 10.35 per cent
annually. Also noteworthy, the actively-managed portfolio outperformed with
less risk: 84 per cent upside capture and 48 per cent downside capture.

Theoretically, if an
investor bought the ETF 18.5 years ago without engaging an active manager, an
investor would have left 3.5 per cent annually on the table.

A different way to invest

There are three key
reasons why an active manager can deliver alpha, despite the emerging orthodoxy
that passive management is the only way to invest.

First, asset class
matters. In the small- and mid-cap space, there only are a handful of analysts
covering most companies, instead of dozens who typically follow large caps.
Active managers who do their own homework enjoy more access to management,
which results in improved research. That’s common when evaluating small-cap
companies.

Second,
concentration matters. There are 2,000 stocks in the Russell 2000 Value Index.
Some active managers select and own a much, much smaller number of best ideas.
In fact, the index has 2,000 best ideas and you can’t get rid of any one of
them. Concentrated active managers need only a handful to succeed.

Third, sell/risk
discipline matters. Active managers have sell and risk disciplines in place, the
index does not. Russell reconstitutes the index annually. Active managers
evaluate what they own every single day. Thus, they have a huge advantage: They
can sell – or buy – whenever they want.

In looking for an
active manager, it’s worth recalling the bestselling work, Common Sense on
Mutual Funds by John Bogle. In his book, he quotes Wall Street Journal
columnist, Roger Lowenstein, who said that the selection of stock investments is
“done best by individuals or small groups of people sharing their ideas and
buying only the very best. A small fund family managing selective portfolios…
can succeed as a group, but no large institution… can order dozens of managers
to outperform. The image can be branded, but not the talent. The people matter
more than the name.”

With the right team
and disciplined process, Lowenstein is right on the mark.

Passive management still works for many investors

The proponents who
claim you can't beat the index are, in truth, correct almost all of the time.
The vast majority of active managers don’t match the performance of their
relevant benchmark.

The question, then,
is whether investors should be satisfied with the me-too performance of the
index. For many investors, the answer is that it’s not worth the risk or
effort. For others willing to identify the managers who deliver alpha, the
rewards can be meaningful and substantial.