As it turns out, 2014 proved to be a very challenging year for active equity fund managers. The S&P 500 reached all time highs, yet close to 90% of US active managers trailed the index. The Vanguard 500, a leading passive index fund, was in the top quartile of all large cap US managers. This outcome, which has happened only five times in the past 20 years, always raises the question of whether active management is worth the money and if low-cost ETFs are the answer. This article looks at some of the reasons why active management can make sense over the long term, particularly for conservative investors.
In today’s shortsighted world, where the financial media is mostly concentrated on soundbites and touting the expert of the day, it can be hard to focus on the long term. But it is in the long term where real wealth is built and real goals get accomplished. So, when conducting annual manager reviews, it should not be a ‘what have you done for me lately’ conversation. It is important to concentrate on a manager’s ability to deliver strong risk-adjusted performance over long periods of time. Capital preservation is the cornerstone of most client goals and investment philosophies and so, in our view, the best way for a manager to add value is to deliver long term returns at or above market indices with below-average risk. With this investment mindset, it’s easier to separate ourselves from the daily headlines and remind ourselves of the benefits of an active management approach designed to mitigate risk. Here are some real world examples:
Patience Pays Off for Value Investing
The value style of investing can provide an enhanced level of capital protection to client portfolios, especially in down markets. In our experience, these managers typically earn their keep during periods of turmoil. And because most crises are unforeseen, we believe that this style of investing should hold a prominent place in a conservative investor’s portfolio.
This type of manager looks for stocks that trade at a discount to their ‘intrinsic value’. To them, this discount is ‘a margin of safety’, and they will not hold any investment without this built-in layer of protection. The trade-off for this ‘downside protection’ feature can be lagging performance in strong markets. This occurs because as markets run higher, value managers tend to struggle to find opportunities because, in their opinion, valuations become too stretched. This can in turn cause many of them to increase the quality of their portfolio holdings and hold significant cash balances, as was the case for active US value managers in 2014. This was not productive for performance last year because the S&P 500’s total return of 13.7% (in US currency) was well in excess of the yield you could earn on cash. (It is interesting to note that the more representative Russell 2000 Index rose only 4.9% last year.)
While value managers may face performance-related criticism in the short term, we believe the style is a prime example of how taking a long view to investing can pay off. For instance, prior to the onset of the 2008-09 financial crisis, many value managers were also facing valuation-related challenges and increased the quality of their portfolio holdings and boosted cash a result. Their conservatism was ultimately appreciated by investors when their portfolios were insulated from the historic drawdown that followed. Many of these managers also outperformed when the markets began to recover as they were able to deploy available cash into stocks at attractive valuations.
Unlike value or other active managers, passive index funds are always fully invested and hold a portfolio that will track the market, more or less. Passive investments are a valuable and legitimate component of a portfolio but they don’t have the same flexibility of active managers to moderate risk when deemed necessary.
The Benefits of Active Management at Home in Canada
Investors in Canadian equities can also benefit from active management. In addition to financial stocks, the Canadian TSX index is dominated by two sectors that are inherently cyclical – energy and materials. Overexposure to these sectors through investing in indexes or index-like funds, adds a level of volatility which may not make sense for many portfolios. Selecting investment managers who concentrate on minimizing risk as well as participating in growth, may tilt the portfolio to be underweighted in the more volatile resource sectors or hold more stable and high quality names within them. This approach can result in underperformance in the short term in the event of a broad scale rally in resource stocks. But, over the long run, this strategy can add an element of stability, such as in 2014, when Canada’s energy sector suffered from the precipitous drop in oil.
The Advantage of Choosing to Own Quality
Focusing on quality companies can also be a good approach for conservative investors, no matter the managers’ respective styles. Quality companies tend to be profitable, well established and less leveraged, and they have sufficient cash flows available to meet their obligations (i.e. interest and dividend payments, capital expenditures, etc.). While the growth prospects for these companies may seem less than other ‘flavours of the day’ in the investment universe, they are often financially well-positioned to deal with periods of heightened volatility and have produced good long term returns. Conservative investors can be comfortable when the performance of these companies lags when the general markets surge. The value comes in the relative outperformance when the investing environment is less favorable. A ‘winning by not losing’ approach has been a very successful strategy for conservative investors over the long term.
As discussed in the previous examples, active management has its merits for the conservative investor who is focused on protecting capital on the downside by minimizing risk in the quest for returns over the long run. It is acceptable and should even be expected that value-oriented active managers will fare relatively less well in strong markets and relatively better in weak markets. Running a few steps behind the fastest runner may not feel like fun, but finishing strong, without major mishap, feels really good and is often more than enough!