Tim Paulin, CFA, is the senior vice president, of investment research and product management at Touchstone Investments. His experience in the financial services industry dates to 1986. Paulin and his team are responsible for product development, as well as identifying, engaging, and monitoring the investment managers that sub-advise current and prospective Touchstone mutual funds and ETFs.
Russ Alan Prince: Over the past couple of decades, consistently negative flows to actively managed equity funds reflect disbelief in the value of active management. In your view, what has the market got right and what might it be missing?
Tim Paulin: Even if there are shreds of truth to the damning conventional wisdom, there is a real methodological problem in making the leap from “the sum of all active management underperforms” to “no single active manager is able to outperform/worth investing in.” We have yet to meet the investor who invests in all active managers or every fund in a particular category. So, whether the aggregate underperforms is irrelevant when it comes to selecting a handful of active funds to populate a portfolio.
We do not argue with the conventional wisdom that, in the aggregate, “Active Management” underperforms “the Market.” That said, the sum of active bets is a close reflection of the market. So, saying active management, in total, underperforms indexing is like proclaiming “the market net of active fees underperforms the market with no fees.” Yet this kind of logic contributes to the migration to indexing we have seen over the past couple of decades.
The more important question is whether such conventional wisdom actually helps investors. Recent research evaluated twenty years of academic literature on active management from the late 90s to the late 2010s. The authors found that the academic literature suggests “the conventional wisdom is too negative on the value of active management.”
When it comes to making individual, active fund selections, we believe it is important to refine traditional metrics many investors have used. A recent academic study concluded that statistics like Morningstar Ratings were the only significant drivers of inflows to mutual funds. But studies from firms like Dalbar and Morningstar suggest that investor returns leave a lot to be desired because of poor timing. Either reliance on ratings and rankings is misguided or something is missing in making fund selection decisions.
While there’s nothing wrong with evaluating past performance, we do feel investors will benefit by also focusing on other characteristics supported by academic research as being associated with future outperformance—strategies that we call “distinctively active.”
Prince: Why should investors care to distinguish among “distinctively active” managers?
Paulin: Sadly, a large portion of active funds have either never exhibited or no longer maintain characteristics associated with future outperformance. Each year, we examine the full universe of U.S. Large Cap and US Small Cap equity funds to understand investor exposure to such funds. We find that three-quarters of assets held in U.S. Large Cap and U.S. Small Cap mutual funds are in funds with at least one of the following maladies inhibiting outperformance:
- Closet indexing is when an active strategy’s investments have a high overlap with indexing. Taking from the conventional wisdom discussed above, it’s hard to beat the benchmark if one invests like the benchmark but charges higher fees.
- Asset bloating is when an active strategy’s assets under management have gotten so large that they can’t invest in a significant number of stocks in their opportunity set.
- Portfolio dilution is when an active strategy invests in 100, 200, or more stocks, often in the name of risk management or diversification but also at the cost of diluting a manager’s top ideas.
Distinctively active managers strive to avoid these maladies. In fact, they seek to deliver the opposite: high active share, “best ideas” portfolios with sufficient asset capacity.
Prince: How is Touchstone helping financial professionals to implement such concepts?
Paulin: A central component of how we strive to deliver value to advisors is via our business consulting efforts. Naturally, there is an investment component to an advisor building and maintaining a differentiated, scalable and defensible practice.
We incorporate our own unique lenses along with more traditional lenses advisors tend to use to illuminate risks and opportunities. A core element of this strategic analysis is our proprietary SCOPE Lens. SCOPE is an element of distinctively active investing and an acronym for traits supported by academic research as related to fund outperformance. The components are Skill, Conviction, Opportunity, Patience and—reasonable—Expenses.
In an evolving environment for financial professionals, we believe it’s important to know the funds you own across client portfolios and periodically evaluate your reasons for owning them. Having a consistently applied methodology and documenting your findings are best practices. Yet a major hurdle for many advisors we have historically engaged is the sheer number of funds that are held among all their client accounts.
Typically, we find 300, 400, or more funds held across the accounts of a single advisor or advisor team. Efficiently monitoring that many funds can require a herculean effort when you consider that spending just 30 minutes per year for each fund held would translate to five weeks of work to monitor 400 funds. In many cases, we have been able to leverage advisors’ practices by incorporating our fund evaluation lenses and streamlining the breadth of their investment solutions.
Russ Alan Prince is the executive director of Private Wealth magazine and chief content officer for High-Net-Worth Genius. He consults with family offices, the wealthy, fast-tracking entrepreneurs and select professionals.
