Active asset management can generate excess returns on a sustainable basis, thus contributing substantially to the creation of value, writes Alex Fung from Vontobel Wealth Management Asia.

By Alex Fung, CEO Vontobel Wealth Management Asia-Pacific

Active asset managers have faced much criticism in recent years, while exchange traded funds (ETFs) – unmanaged vehicles that passively simulate the performance of an index – have seen a strong rise in popularity.

It is estimated that roughly one-third of equity investments worldwide are passively managed, and the trend is increasing. The popularity of index funds is partly due to their favourable cost structure, and partly due to rising investor scepticism regarding the abilities of active asset managers.

Theoretical Underpinning for Passive Strategies

Many active managers are unable to «beat» the market over the longer term, which would justify the additional – sometimes high – management fees payable for their services. The so-called «efficient markets hypothesis» (EMH) provides a theoretical underpinning for passive strategies.

Markets are assumed to be information-efficient, leading to the conclusion that active asset management cannot consistently yield returns above the market average. Promoted by Eugene Fama in the 1960s, the hypothesis emerged as the leading financial market theory in the 1970s.

Irrational Market Participants

Despite the convincing theoretical foundation of the efficient-markets hypothesis, it has been observed in practice and documented in several empirical studies that markets do not always reflect the totality of available information, and that market participants' actions are often irrational and influenced by psychological factors.

This explains the occasional tumultuousness of markets, driven by either euphoria or panic. Behavioural finance research has revealed that people often exhibit a cognitive dissonance and are subject to human error in their investing behaviour. For example, they may have an exaggerated perception of profits or losses or engage in a herd mentality with regard to market movements.

Popular Equity Indices

Holders of passive investment instruments participate directly in every inefficient movement. A passive approach can also lead to concentrations in certain sectors or in particular shares that are not justifiable from a portfolio diversification standpoint.

For example, investors in popular equity indices are generally overweighted in equities and sectors with high prices relative to the fundamentals, while less well-known securities representing better value languish and are underweighted. Active strategies can take advantage of such inefficiencies and temporary misvaluations, deviating from the benchmark to add significant value for investors.

Complementing Strategies

Active and passive strategies are not mutually exclusive, however, as active managers may make targeted use of select passive instruments in certain segments. Typically these are highly liquid markets that evidence a relatively high level of efficiency.

The value of information processing is greater in certain segments than in others, however, and it is there where taking an active approach makes more sense. The mid-cap to small-cap range is especially suitable, comprising less liquid stocks with less analyst coverage.

Active Investing «Done Right»

It is universally accepted that temporary market inefficiencies can be profitably exploited through active management. Yet only a minority of active managers successfully achieve sustained above-index returns net of fees.

This is an inevitable mathematical truth: the market is by definition the aggregate of participating investors; accordingly, the totality of active investors (managers) comprising the market cannot outperform the index. Some managers outperform, others underperform.

There will always be active managers who beat the market, because active asset management opportunities increase when more investment assets are passively held.

Careful Asset Manager Selection

The challenge for investors is thus to identify those active asset managers able to generate above-market returns on a sustained basis. While a manager’s «track record» or historical performance is important, the future outlook must be considered as well.

Relevant factors include a clear investment philosophy, a disciplined and structured investment process, effective analytical capabilities and a diverse professional environment that values and attracts a broad spectrum of experience, expertise and ideas.

Other important considerations include how well established the organisation is, the consistency of its business model and to what extent it successfully maintains long-term relationships with satisfied clients.

Alex Fung is the Chief Executive Officer of Vontobel Wealth Management Asia, based in Hong Kong.