PLANADVISER - May/June 2020 - 29

Indices Versus Active] scorecard. For last year, 71% of largecap
U.S. equity funds lagged the S&P 500, and, for the 10
years then ended, 89% underperformed. For 2019, in isolation,
small- and mid-cap funds fared far better-62% and
68%, respectively-and outpaced their benchmarks, but
only a few won over the long term.
Choosing managers is further complicated by a low
persistence of outperformance. " We find that, of those
managers who outperform in one year, only half go on to
beat the next year, " observes Aye Soe, managing director at
S&P Dow Jones Indices. " Managers need a long time to prove
themselves, and we know for certain that most investors
don't have that time horizon to be tolerant. "
To be fair, there are asset classes where active management
is more successful. In equities, for example, managers
of international and emerging markets portfolios
often show better results. Wilshire
Consulting found that, last year, managers
of developed ex-U.S. equity portfolios beat
benchmarks by 1.26% at the median and
that the median emerging markets equity
manager outpaced indexes by 1.42%.
The essence of active management is
historical performance: Meeting with managers, understanding
the reasons for their results, and then making a
qualitative assessment on whether that historical performance
is going to persist, " O'Meara says.
At Francis Investment Counsel, in the Milwaukee suburb
of Brookfield, Research Director Ed McIlveen details his
firm's multilayered manager-selection process. " Our quantitative
side looks at performance over full market cycles,
which covers the last 10 years. We evaluate absolute and
relative
performance,
and
risk-adjusted performance
through Sharpe ratios. "
A screen for consistency reveals whether managers have
won more often than not, and keeps out funds that deliver
extremes of performance, he says. " Our process tells sponsors
whether their goals are being met versus managers'
building portfolios of winning securities
while sidestepping the losers. The first
quarter of this year provided the right circumstances, as
shares of airlines, retailers and energy companies plummeted,
while stocks soared for companies that profit from
people staying home, as well as those working on solutions
for treatment and eradication of COVID-19.
" This environment will generate a lot of 'I told you so'
moments, and one will be whether active management is
able to succeed, " Sampson observes. " Passive funds have no
defense against falling markets and are at the mercy of the
market on the way back up. Active managers have a choice
of what they own and can do something about it. " But, he
cautions, " whether they succeed or not is another matter. "
To that point, New Zealand-based Copley Fund Research
reports that, for 2020's first quarter, U.S. active equity
managers posted the worst performance since 2016, lagging
their benchmarks by 1.44%.
Still, many DC plans present actively managed funds
alongside passive options. " As advisers, we're agnostic on
active versus indexing and think a sponsor should offer a
wide array of choices to the employees, " Sampson says.
Selecting Active Funds
Given the low chances of success, how does an adviser
select funds to present for a committee's consideration?
" Historical data on performance is potentially misleading for
a forward-looking decision, " says David O'Meara, head of DC
strategy at consultant Willis Towers Watson in New York
City. " There has been plenty of research that asks whether
a manager's performance over the past five years provides
insight over the next five, and the answer is 'no.' In many
instances, outperformance can be a sell signal.
" It really takes another layer of due diligence beyond
" This environment will generate
a lot of 'I told you so' moments,
and one will be whether active
management is able to succeed. "
peers or benchmarks. We can't ask a sponsor to wait five or
six years for one big year to arrive. " Francis also analyzes
managers' alpha generation versus their portfolio turnover,
to determine which decisions were fruitful and when the
investment process had its greatest effect.
On the qualitative side, " We need to understand why
they own their stocks, and we meet with them to discuss
four or five in depth. That reveals pretty quickly who knows
what they are talking about, " McIlveen says. In the end, the
process yields a handful of managers-about four in any
category-and the names rarely change.
" It's also important to have a way to move on from a
manager, " notes Ben Taylor, senior vice president and head of
tax-exempt DC research at consultant Callan, in San Francisco.
" I tell my clients that if I don't occasionally recommend
to terminate a manager that is currently outperforming, I'm
probably not doing my job. " In such cases, a firm might be
shooting the lights out but not hewing to the style it was
hired to deliver. He acknowledges that such advice can draw
funny stares from clients, but " if I only tell you to terminate
a manager after they have underperformed or a key portfolio
manager has left, then I'm just locking in the losses
after the fact. "
Jeff Stakel, a principal at Casey Quirk, a Deloitte Consulting
business in Stamford, Connecticut, notes that managers
have complained for years that the lack of volatility in the
market created a tough environment for active management
to outperform in. With the COVID-19 crisis, " Volatility has
been reintroduced, and now is the time for active managers
to prove their value propositions-or not. Those who can
outperform will be rewarded with assets, and those who do
not will be forever challenged, " he says. -John Keefe
planadviser.com May-June 2020 | 29
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