How Good Policies Gone Wrong Are Killing Active Management

Fund managers are missing out on bigger gains from their brightest bets.

Active managers who focus only on their best ideas can provide almost 300 basis points in annual excess returns over a rolling five-year period, according to new findings fromGDC Research, a consulting firm focused on advisors, wealth management and asset management. Adopting a multiple-manager approach — putting more than one management team in charge of a single fund and famously used by Capital Group's American Funds — can also increase returns.

Dennis Gallant, president of GDC Research, says retail and institutional investors want active managers to provide diversification and to avoid straying far from popular benchmarks. But this behavior, often codified in investment policy statements, undermines the skill of best active managers by diluting the outsize returns of their highest conviction ideas.

Using Morningstar data for its analysis,Gallantsays the firm found that when a fund manager invested solely in its best ideas, they were able to generate significant excess returns. The average of the concentrated portfolios that GDC assessed returned 290 basis points of outperformance over the Standard & Poor's 500 index on an annual basis. This was true even though the average actively managed fund does not beat its benchmark.

That's because the larger a fund's so-called beta anchor, the less room active managers have to pick their best investment ideas. Beta anchor refers to the securities in which the fund is invested to keep the portfolio closely aligned with its benchmark. Others call these types of funds closet indexers.

Gallant says a large proportion of funds used in defined contribution plans have a 75 percent or larger beta anchor, meaning the portfolio manager can only invest the remaining 25 percent of the fund in high-conviction ideas.

"So you can have a very good manager behind the wheel, but the excess returns are watered down," Gallant said in a phone interview. "The beta anchor effectively dilutes any benefit from a fund manager's selections." He said that "it's difficult to break away from these funds because you're subject to criticism."

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GDC Research is recommending that advisors and consultants look to achieve diversification through other means, such as a more detailed asset allocation plan. Trying to diversify through individual funds only hamstrings portfolio managers and hurts the returns of active managers.

The firm found that adding four to five managers to the helm of funds also provides a better chance at outperformance. Most asset managers stick to a single manager or team, though there is evidence a multi-manager approach works better, adds Rob Steele, a GDC researcher and Gallant's partner on the study.