We’re quick to highlight that large proportions of active funds have unreasonable costs or come with brokers’ sales commissions. These products are often sold to investors by salespeople with profit motives or are the only options in captive situations like 401ks or annuities. Including performance results from these inferior strategies skews the averages for active managers as a group. The first step in our fund selection process is to eliminate these poor options from contention. Once the herd is thinned, the case for high-quality active funds strengthens dramatically because comparative fund performance relative to benchmarks notably improves.
Engrained in our support for active management is a rigorous fund selection process. We look for numerous features when selecting active strategies for client portfolios. Fees must be reasonable and justified by long histories of outperformance. We won’t pay active management costs for funds that mimic indices.
Active managers can only outperform an index by deviating from it and the size of their allocation decisions matter too. A strong risk management process is also important. Active managers have tended to outperform passive strategies in declining markets by losing less. Investors may be underappreciating this point since equity markets have experienced few measurable setbacks since the financial crisis.
A disciplined selection process significantly increases investors’ prospects for choosing active managers that will be able to outpace index returns. After the selection process, investors should frequently monitor their fund managers’ performance in comparison to the fund’s benchmark as well as against the peer group of funds within the same category. This isn’t a “set it and forget it” process. Oversight is required and changes are sometimes necessary.
Diversification is one of the most important components of efficient portfolio management. Spreading exposures across various asset classes reduces the overall portfolio risk and volatility. We believe that diversifying across active and passive strategies is just as prudent. Both strategies have a place in portfolios. And neither should be judged based on isolated data points but on the holistic picture and the benefits versus drawbacks associated with each specific strategy.
Warren Buffett certainly isn’t the only wildly successful active manager. Many more have added tremendous value in the form of excess returns for their investors. This point may be easily missed if the focus is on average results or if investors indiscriminately accept unbalanced commentary that passive strategies are the optimal solution. However, once a stringent investment process is incorporated to eliminate subpar options and identify top-tier active strategies, the data changes significantly. Without such a process, investors may be relegated to accepting mediocre active managers or settling for index returns. Not us. We believe outperformance is extremely valuable and very achievable.
Daniel Eye, CFA, serves the firm as senior portfolio manager and investment committee lead for Roof Advisory Group. Roof Advisory Group is an independent registered investment advisor located in Harrisburg, Pa., serving clients across the USA for almost 20 years.