The Skill of Active Management
July 15, 1924 marked the birth of the first mutual fund and started what would be a near-century of stock pickers looking to beat the market. The MFS® Massachusetts Investors Trust fund is still around today, approaching 100 years of active management. Since its inception, thousands of funds have opened and closed with varying levels of success in adding value above broad benchmarks.
These funds are launched with the promise of bringing the skill of stock picking to the average investor hoping for returns far in excess of a simple passive investment. This skill, necessary in order to justify the material fee, is based on the ability to dig through company financials, talk to the right people at the company, or draw variant conclusions on public data. Each stock picker believes there is a level of inefficiency in the market which causes certain stocks to be mispriced. If he can just single out enough of them, he can populate his portfolio and diversify away risk.
Markets will never be perfectly efficient; there will always be a level of mispriced information upon which investors can act. However, stock picking is only one of the skills required of active management, and more importantly, the least reliable one. There are three reasons for this:
- Outperforming is difficult: Over the last 10 years, out of 110 large-cap equity managers, only 54 of them have outperformed their benchmark before fees.
- Fees are a drag: When a standard fee of 60 bps is subtracted from that return, the number of outperforming managers drops to 22.
- There is a cyclical element to active management: Of those 22 managers, all experienced at least one three-year period during which they lagged their benchmark.
For these reasons, Balentine typically chooses to be passive in efficient asset classes. However, in certain instances—the ability to access a market and the ability to effect change within an investment—active management may be more appropriate. These opportunities are most often found in our Manager Skill and Private Capital building blocks.
For the past two years, Balentine’s Investment Strategy Team has transitioned Manager Skill from traditional hedge funds to diversifying strategies which are becoming more broadly accessible through innovations in capital markets. Last year brought allocations to reinsurance and alternative lending. This June, Balentine added core real estate to the Manager Skill building block. At $12 trillion, real estate investments make up a meaningful amount of the global market and therefore merit a strategic place in our portfolios.
So-called core properties (fully leased) are in good health and located in attractive markets. These buildings require little attention from the manager while providing monthly cash flows and price appreciation. Core properties are similar, yet distinct, from core-plus properties, which consist of buildings in attractive locations, but require slight modifications (e.g., updated common areas or new mechanical systems) before they can be considered core properties.
Core real estate assets have a stable return stream due to the long-term nature of most leases. Leverage, typically ranging from 25% to 40%, is also lower than classic core-plus properties. Another reason this investment is so attractive is its uncorrelated nature to both bonds and stocks. Interest rates largely dictate price activity in the fixed income and equity markets, while supply and demand drive real estate prices. It may be tempting to draw an association between economic well-being and demand for real estate, but outside of 2007 and 2008, when a real estate bubble pushed the economy into recession and crashed the stock market, correlations have been rather low over the past 40 years.
The logistics, reporting, and regulation around this undertaking requires an immense amount of skill, as it is more than the repackaging of stocks and bonds in an attempt to diversify a portfolio. Investing in these types of asset classes allows us to create excess return in our portfolios by allocating to an asset class not previously available, much like the traditional investor of the 1960s. To access the allocation to core real estate, Balentine chose a closed-end interval fund (INF), the benefits of which include increased liquidity, no minimum investments, greater diversification, and simplified 1099 tax reporting. The costs are an extra layer of fees and potentially duplicative REIT exposure, both of which, in our view, are overshadowed by the benefits.
For our Private Capital building block, we prefer the ability to effect change in an investment. The “active” part of active management in stock picking typically ends after the point of purchase. After an analyst convinces her portfolio manager to buy her recommendation, she transitions to “watch mode” to ensure her thesis plays out. This consists of quarterly calls, an occasional conversation with management, and a yearly deep dive into the 10-K. Rarely during this process does the skill of the analyst actually create change in the company, and how could it when they represent 0.1% of the investor base? Their active approach has earned them a passive seat along the way.
Contrast this to active management in the private capital realm. A venture capital investor will conduct due diligence of a prospective company using financial statements, management discussions, and variant conclusions, all leading to an investment in the startup. Unlike the example above, this venture capitalist can own 25% or more of the company. It is at this point that the true skill of active management takes over. The seasoned venture capital investor will develop business plans, hold material voting rights, make introductions, place C-suite personnel, and do everything he can to ensure the company succeeds. We believe success in the private capital world is sticky due to this expertise and the ability to effect real change within a company. For this reason, we are willing to ask clients to accept long lockups and to pay performance fees.
While the MFS® Massachusetts Investors Trust fund will likely endure another 100 years of active management, it is impossible to know which of those years are going to be feast and which are going to be famine. We choose instead to focus our active management efforts on the other two skills since we are more confident of their ability to drive returns in our portfolios.
 See p. 14 of our 2017 Capital Markets Forecast for more detail.
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