Clare Flynn Levy, Essentia Analytics

New study suggests that fund managers can outperform index funds


Active fund managers could preserve more than 1.2 per cent per year, net-of-fees, of outperformance versus passive index funds, according to Essentia Analytics’ latest report.

Essentia Analytics’ research shows that active fund managers have a “window of opportunity” per position within which they can outperform index funds by a margin significantly greater than their active management fees.
 
Essentia’s analysis defines the “window of opportunity” within which managers can exit their positions and realise an index-beating return, net-of-fees. According to the report, on a typical position held for one year, managers have approximately nine months to act and still produce net-of-fees gains above their benchmark index.
 
Active managers, on average, tend to underperform their benchmark indexes, net-of-fees. The Essentia study also showed that the alpha produced by active before it decays is in excess of the fees they charge – over 1 per cent a year in net performance. With this mind, if active managers exit their positions at or near the top of their alpha curve, they have the potential to deliver better performance than index funds.
 
The Alpha Lifecycle study, documented in two research papers plots the average trajectory of each position in active managers’ portfolios.  It found that, on average, the alpha generation of a given position tends to rise steadily early in its lifecycle, then plateau, then fall dramatically. On average, managers hold on to their stocks well past “peak alpha,” selling at a point at which they have given up all of the position’s outperformance. Essentia attributes this to the  “endowment effect,'' whereby investors overvalue something by virtue of their ownership of it.
 
Low- or no-fee index returns are increasingly seen as a more cost-effective option than active funds, in which managers attempt to beat the broader market indexes, for a fee. The Essentia report shows that active managers outperform index funds – well in excess of their fees – early in the lifespan of their positions. However, active managers have a tendency to hold on to their stocks too long and the gains they made early on tend to diminish.
 
Essential Analytics CEO, Clare Flynn Levy, says: “The active fund management industry is well aware that assets are flowing to index funds because fund managers have consistently underperformed their benchmark indexes. But from our research, we can see that this trend is neither inevitable nor unstoppable.
 
“This research challenges the active vs passive orthodoxy – which seems to assume that active portfolio managers cannot improve their performance – and fundamentally changes the discussion. It’s no longer a given that passive fund investing is more cost-effective than active. It’s now whether – and if so, how – active managers can realise the alpha we know they’re generating before it decays away.”

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