How To Know When Active Management Performs Best

How To Know When Active Management Performs Best
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Hedge Fund Launches Jump Despite Equity Market Declines

Last year was a bumper year for hedge fund launches. According to a Hedge Fund Research report released towards the end of March, 614 new funds hit the market in 2021. That was the highest number of launches since 2017, when a record 735 new hedge funds were rolled out to investors. What’s interesting about Read More

  • Active equity fund performance depends on the stock picking skill of the investment team as well as current market conditions.
  • Recent academic research confirms that returns to stock picking skill rises in tandem with increased stock return cross-sectional dispersion and skewness, along with greater market volatility.
  • Active equity opportunity (AEO) is estimated using these measures to show how active the emotional crowds are at driving stock return dispersion.
  • Returns-to-skill is strongly influenced by the current market environment as captured by Active Equity Opportunity.
  • The impact of AEO on stock picking is largely independent of where we are in the business cycle.
  • Returns-to-skill varies positively with the degree to which a fund is truly active, as measured by conviction, tracking error and size of assets under management.
  • It may be beneficial to allocate more to stock picking funds and less to market exposure funds as AEO rises.
  • When AEO is low, it still does not make sense to invest in closet indexers, since, while they outperform their truly active counterparts, their average alpha remains negative.

At the core of the active-passive debate is the question of whether active equity managers are skilled enough to cover costs. A large number of studies show the average fund underperforming a passively managed portfolio, revealing that stock-picking skill is on average insufficient to offset fees.

On the other hand, many studies demonstrate truly active funds, as contrasted to closet indexers, do outperform. Truly active funds are those with high active share, low R-squared with respect to the fund’s benchmark, smaller AUM (generally less than $1 billion), strategy consistency and large positions in best-idea stocks, among other identified fund characteristics. Unfortunately, distribution incentives strongly encourage funds to grow excessively large and become closet indexers, leading to the average industry underperformance, as closet indexers far outnumber truly active funds.

In recent years, however, many truly active funds have underperformed as well. This begs the question of whether the returns to stock-picking skill varies over time. Indeed, there is considerable anecdotal evidence that stock picking is effective in certain market environments and not in others.

Recent academic research confirms this evidence. In particular, several studies (here, here and here) show increasing cross-sectional stock dispersion (the cross sectional standard deviation of returns from either individual stocks or a portfolio of stocks), and VIX are predictive of increasing returns-to-skill. This study shows that positive skewness (the asymmetry of a probability distribution in which the curve appears distorted or skewed to the right) plays a major role in portfolio and market performance.

To help understand this relationship, consider a fishing analogy. A skilled fly fisherman knows the best time of day to fish, which fly to use given the conditions and where in the river to cast. But regardless of how skilled the fisherman is, if the fish are not biting, few, if any, will be caught. Successful fly fishing is a combination of skill and opportunity. Skill is the result of the fisherman’s talent and experience while opportunity is largely outside his control. Using the number of fish caught as an indication of skill is problematic.

Read the full article here by C. Thomas Howard, PhD, Advisor Perspectives

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