What we are proposing is, in effect, a new social contract between investors and professional fund managers. Rather than assigning credit or blame based on relative performance versus the S&P 500, investors should “own” that part of the relative performance that can be sourced to asset allocation decisions, or the initial decisions to deviate away from cap-weighted indices.
Why compensate or terminate managers based on the systematic aspects of the relative performance that lie outside managers’ control (e.g., small-caps systematically underperforming large-caps, value underperforming growth and vice versa)?
In addition, professional fund managers should be assessed against smart-beta counterparts on a fee-adjusted basis and over longer periods of time beyond the typical three-year time horizon.
Three years is not enough to judge the success or failure of active management since: 1) three years does not cover a full market cycle; 2) portfolio decisions can take longer time to bear fruit; and 3) short-term performance evaluation invariably leads to a short-term mindset on the part of the manager (e.g., the temptation to “trade” one’s way out of a period of underperformance).
And what would investors get in return for shouldering part of the residual return due to asset allocation and a willingness to extend the time horizon for evaluating active management? Lower fees.
Pricing on smart-beta indices will drive fee compression; however, active management can instill investor loyalty by incorporating time horizon of investments held in the fund as part of the fee equation. The longer the investment held, the lower the fee. Perhaps introduce a lower-fee share class based on meeting a minimum threshold of investments held in the strategy.
Patience is what is required for successful implementation of active management, but patience is in short supply in our industry. The transparency and cost-effective delivery of smart-beta ETFs can enable better benchmarking of active management as well as the appropriate assignment of relative performance rewards/shortfalls between the asset allocator and the active manager.
Active management can thrive if its business of professionally managing portfolios is more properly aligned with the investment needs of the firm’s clients, where both parties can enjoy longer time horizons to judge whether or not the relationship is working out.
Benjamin Lavine, CFA, CAIA, is chief investment officer of 3D Asset Management. At the time of this writing, 3D Asset Management did not hold any of the ETFs listed in the article. The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of October 18, 2017, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or emailing [email protected] or visiting 3D’s website at www.3dadvisor.com.