When choosing an active manager, multiple factors need to be considered—a single data point from an index provider or data vendor doesn’t paint the full picture. Investors can approach their due diligence using these three pillars: philosophy, process and performance. Taken together, the pillars can play an important role in helping you understand the merits of a particular active fund or strategy.
1. Philosophy: This may be the most important pillar to consider as you start your due diligence. Because an investment manager’s philosophy is core to all other functions and serves as the groundwork for decision-making, it’s essential that an active manager’s investment philosophy aligns with your own. Knowing a manager’s philosophy can help surface any potential bias he or she may bring to the table, and it can also help you understand how the manager expects to explore inefficiencies within the market to generate alpha.
2. Process: Along with philosophy, process drives performance. You should understand a manager’s style and how well he or she adheres to it over time. You can gauge the investment process by having a complete understanding of the investment decision life cycle, from idea to trade execution. Looking at an active manager’s investment process step-by-step will help uncover what is truly going on in a portfolio.
3. Performance: In the end, performance is key. No matter how great a manager’s investment philosophy and process sound, the strategy may not be worth the fees if he or she cannot deliver expected performance results. While singular data points are easy to remember and make for great headlines, there is always more to the story. When analyzing active manager performance, keep these additional considerations in mind:
The importance of rolling periods can be seen in this real life example of two active small-cap value managers. At the end of December 2013, Manager A outperformed the benchmark Russell 2000® Value Index and Manager B substantially across nearly all standard periods, as shown below.
But when looking at the chart below, which shows performance on a rolling 36-month basis, Manager B’s track record shows more consistency. If you decided to invest with Manager A based on the stellar performance as of December 31, 2013, you would have gone on to underperform the benchmark by 11% annually in the following three years.
Past performance is not a reliable indicator of future performance. Index returns reflect capital gains and losses, income, and the reinvestment of dividends.
As these pillars illustrate, basing your active management decision on a well-rounded approach may provide you with more clarity and comfort before making your investment decision. They can also help you choose an active fund or strategy that will fit your needs.
Active Management: A portfolio management approach that uses a human hand, such as a single manager, co-managers or a team of managers, to select, adjust and change a fund’s holdings over time.
Alpha: A gauge of risk-adjusted outperformance relative to a benchmark.
Factor Premia Investing: An investment approach that focuses on underlying factors that define risk, return, and correlation. This approach seeks to explain why some asset classes move together and offer more efficient portfolio construction than other methods.
Passive Management: An investment strategy that removes the active human hand from the process and replaces it with systematic, rules-based approaches to securities selection. Passive investing, notably index investing, is relatively cheap because it typically limits portfolio turnover and because the passive investing does not involve relatively costly research.
Russell 2000 Value Index: An index designed to measure the performance of the small capitalization value sector of the U.S. equity market.
Smart Beta: Smart beta defines a set of investment strategies that use alternative index construction rules to achieve outperformance over first-generation market capitalization based indices. Smart beta indices isolate six particular “factors”—small size, value, high yield, low volatility, quality and momentum—and are again designed to deliver better risk-adjusted returns than cap-weighted indices.
Important Risk Information
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without State Street Global Advisors' express written consent. The views expressed in this material are the views of Matthew J. Bartolini through the period ended March 2019 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Forecasted asset class returns are based upon estimates and reflect subjective judgments and assumptions. There can be no assurance that developments will transpire as forecasted and that the estimates are accurate. Actively managed ETFs do not seek to replicate the performance of a specified index. The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data. While diversification does not ensure a profit or guarantee against loss, investors in Smart Beta may diversify across a mix of factors to address cyclical changes in factor performance. However, factors may have high or increasing correlation to each other.