GUEST ARTICLE: Active Investment Management: Alive, Well And Delivering Alpha

Kevin Bernzott

8 October 2013

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.