Optimally Utilizing Active and Passive Management
It’s no secret that active managers have a very difficult time beating their benchmarks, especially after fees and taxes.
In particular, large cap managers have an extremely hard time adding alpha (excess returns) because the stocks they buy and sell are heavily followed by the Street. In other words, the market for large caps is pretty efficient and there is not a lot of miss pricing for the managers to take advantage of. So, unless you are Warren Buffett, to beat the benchmark you either have to take more risk than the benchmark or get lucky. Taking additional risk is not particularly desirable and forecasting luck is impossible. The bottom line is that it’s smart to index your large cap exposure. This strategy alone will likely add 100 bps to your annual large cap returns.
Small cap managers, however, are typically able to add some alpha versus their benchmarks. Smaller stocks are less efficient and often neglected by Wall Street analysts. Why? Small companies are generally not very good investment banking clients. They don’t generate the big fees that large firms do. Using a good active manager in the small cap sector will often add 200-300 bps of returns versus a small cap index fund.
International managers typically add alpha as well, but not to the extent of small cap managers because the fees are higher. Still, an excellent international manager can add 100 bps or more of excess returns after fees.
On the fixed income side, you’ll generally want to avoid active management in treasury, corporate and high yield bonds. What little value these managers can add through security selection, sector bets and duration management are more than offset by the fees they charge. Granted, no true index funds exist in the bond world, but Barclay’s has introduced enhanced index exchange-traded funds with their low cost iShares. Two of them are the Lehman Aggregate Bond Fund and the Treasury Inflation Protected Securites Fund under the tickers AGG and TIPS. The expense ratios on these funds are only 20 bps compared to 50 bps or more for active funds.
In particular, large cap managers have an extremely hard time adding alpha (excess returns) because the stocks they buy and sell are heavily followed by the Street. In other words, the market for large caps is pretty efficient and there is not a lot of miss pricing for the managers to take advantage of. So, unless you are Warren Buffett, to beat the benchmark you either have to take more risk than the benchmark or get lucky. Taking additional risk is not particularly desirable and forecasting luck is impossible. The bottom line is that it’s smart to index your large cap exposure. This strategy alone will likely add 100 bps to your annual large cap returns.
Small cap managers, however, are typically able to add some alpha versus their benchmarks. Smaller stocks are less efficient and often neglected by Wall Street analysts. Why? Small companies are generally not very good investment banking clients. They don’t generate the big fees that large firms do. Using a good active manager in the small cap sector will often add 200-300 bps of returns versus a small cap index fund.
International managers typically add alpha as well, but not to the extent of small cap managers because the fees are higher. Still, an excellent international manager can add 100 bps or more of excess returns after fees.
On the fixed income side, you’ll generally want to avoid active management in treasury, corporate and high yield bonds. What little value these managers can add through security selection, sector bets and duration management are more than offset by the fees they charge. Granted, no true index funds exist in the bond world, but Barclay’s has introduced enhanced index exchange-traded funds with their low cost iShares. Two of them are the Lehman Aggregate Bond Fund and the Treasury Inflation Protected Securites Fund under the tickers AGG and TIPS. The expense ratios on these funds are only 20 bps compared to 50 bps or more for active funds.
posted by Never-Limp at 8:22 AM
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