Follow the market or try to beat it?

Seeking an edge with active management

There are many approaches to active management but common to all is the belief that markets are not fully efficient and that security prices don’t always reflect all the information available to investors. As such, the belief is that it is possible to outperform the market through the application of a repeatable process.

In-depth research vs. data-driven analysis

While some active managers use a combination of techniques, there are generally two main approaches: fundamental and quantitative.

• Fundamental asset managers

  Fundamental asset managers tend to rely on deep expertise on companies, sectors or countries built from detailed analysis of financial statements and market trends. They may engage and challenge the company’s management to build confidence in their investment thesis. They will also incorporate views about the competitive landscape and the macro environment.

  Fundamental managers, in either equities or fixed income, typically have dedicated research analysts supplying ideas to a portfolio manager who is responsible for selecting and weighting the securities in the portfolio. While in equities reseachers may take a narrower focus on a company or sector, in fixed income researchers may need to incorporate a macro perspective due to the sensitivity of bonds to macroeconomic variables like interest rates.

• Quantitative asset managers

  Quantitative asset managers tend to rely on data heavy analysis and processes to identify inefficiencies and early trends. Quantitative managers believe that investors may be swayed by emotions and become too attached to a company or idea without supporting data. They may, for example, not participate in a company’s earnings call, but may use text-mining software to review the transcripts of other companies’ earnings calls to try and capture the sentiments and views of investors. In quantitative asset management, portfolio managers generally follow set construction rules around risk and expected returns — once again to minimize human biases.

  Over on the data-driven fixed income strategies, the focus will be more on metrics like credit ratings and sensitivity to interest rate changes.

Differences in approaches lead to differences in portfolios. Quantitative portfolios tend to be larger in number of securities and remain closer to the benchmarked index in terms of security weights, country and sector distribution. On the other hand, fundamental portfolios are usually more concentrated and may deviate further from the benchmarked index, representing the portfolio manager’s conviction in a given security or theme.

Tracking the market with passive management

Passive managers do appear to have an easier task. If you are trying to track a market index, surely you just buy all the securities in that index, in exactly the same proportion, right?

In theory yes, but real-world frictions play an important role in shaping the approach and choices of passive managers. It starts with the asset class and the index chosen to represent it.

Equity indexes include all the relevant publicly listed companies for a given market. MSCI’s broadest equity index is the MSCI ACWI + Frontier Markets IMI Index which has over 9,000 constituents. Country specific indexes will have a lot less, like the MSCI USA Index with around 600 names. On the fixed income side, indexes tend to include more constituents, both at single country and at a global level. For example, the Bloomberg Global Aggregated Bond Index, which includes both government and corporate bonds, has nearly 30,000 securities.

How to stay close to the target index

Passive managers also need to address regular index rebalances to ensure their portfolios remain close to their target index. While an index will reflect those changes seamlessly, passive managers will need to trade to track the index and that will generate costs. Those costs may have a negative impact, potentially causing the portfolio returns to drift away from the index returns.

In addition, companies do not stand still. There may be mergers, acquisitions, defaults and spin-offs which passive managers need to address in the portfolio, while index providers address them in the indexes.

Passive management isn’t easy. Although it may seem like a simple concept, it is complex to implement correctly.