Lesson type: Think like an investor

Demystifying active management

Active management can deliver superior diversification and investment returns to your portfolios, but how do you choose the right manager - and the right strategy?

Broadly speaking, active management can be defined as a parcel of securities (whether equities, bonds or a combination of both) chosen based on their individual merits rather than because of their placement within a particular market index - say, the S&P/ASX 200. Ideally, these securities are selected via a rigorous due diligence process and will, in aggregate, deliver above-market returns over rolling multi-year periods.

This style of management can be distinguished from index management, where a particular strategy aims to replicate the performance of specific indices before fees. Active strategies have long been used alongside their index counterparts so that an investor can reap the rewards of general market movements while also gaining the (potential) extra performance from a particular active strategy.

When finding the right one for your portfolio, there are a few key issues to consider:

Performance

While all active managers will note that “past performance is not an indicator of future performance,” it’s worth considering how a particular strategy has performed over a specific period – say, five years on an annualised basis – compared to both its peers and the broader market. It’s entirely possible for a particular manager to experience periods of lower performance over certain periods, but if the strategy has performed well overall, this is a good starting point.

The flipside of this is risk. It may not always be the best option to pick the star performer in a particular asset class – Australian shares, for example –  because this manager may have taken on an unnecessary level of risk in order to achieve those returns, potentially exposing its investors to sharp downturns in particular periods.

A common industry benchmark to determine an actively-managed fund’s risk-adjusted performance is the Sharpe ratio, and a quick Google of a fund and its Sharpe ratio will generally yield comparative results - it’s worth comparing similar funds’ Sharpe ratios (the higher the better) as well as their overall performance, as this will give a clearer picture of the level of risk you’re taking on.

Fees

Due to their bespoke nature, actively-managed funds will often carry higher fees than index funds. These can include a blend of management and performance fees – the latter of which involves the manager achieving a certain level of performance over a certain period. Some managers forego one or the other, so it’s important to read carefully through a fund’s product disclosure statement (PDS) to determine what exactly you’d be paying for much how much you plan to invest.

Fees are a critical consideration for investors because if there’s a suboptimal balance between performance and costs, any of the extra performance a manager generates can potentially be eroded by the fees you’re paying – arguably defeating the purpose of investing in an actively-managed fund in the first place.

Diversification

Ask yourself what a particular active strategy is actually adding to your portfolio. If you’re just paying extra fees for a level of performance that closely follows the index a fund is aiming to outperform over multiple periods – in the industry, this is known as “index-hugging” – it’s likely that fund won’t deliver any diversification benefits to your investment strategy.

Balancing the above two points, you’re looking for a manager that can deliver you three things: a favourable risk-adjusted return, a fee mix that won’t erode that return over the long-term and performance that’s sufficiently distinguished from an underlying index so as to make the investment worthwhile.

Ultimately, choosing the right strategy to complement your existing investments will take some research, but asking the right questions here can pave the way to a better choice and investment outcome.

 

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