Morningstar Magazine - June/July 2018 - 90

Investors

time indeed. Funds that had a 15-year track record
of outperforming their benchmark had, on
average, a 10-year period of underperformance during
that time. Ten years is a little longer than most
advisors' and consultants' time horizon.

Johnson: It's sort of a cascade of conviction.
The conviction of the managers themselves in the
portfolio that they've constructed has to persist
through that span. The conviction of the firm that's
sponsoring those managers, that's given them
a desk, given them a place to hang their hat every
day, has to persist over that span. And the
conviction of the end investor ultimately has to
persist throughout.
If we're going to use highly active managers, how
do we succeed in doing so?

Inker: Probably the most important factor
is the confidence that the end investor has that the
manager's approach is a good idea. If the end
client is lukewarm on whether tactical asset allocation works, they are going to fire an active
tactical asset allocator during a period of underperformance. Institutional investors who have
done a good job with highly aggressive managers
tend to go in with a strong philosophical
preference. They have hit upon a style in which
they are confident in their ability to find
talented managers, and they have been patient
when those managers go through a tough period
of performance.

The combination of having a low active
share and high fees is probably the strongest
predictor I've found for underperformance.

Cremers: "Aggressive" needs to be carefully
defined, and high active share doesn't mean that
the manager is necessarily aggressive. A lot
of high active share managers do security
selection in a way that's well diversified and they
may end up with total volatility that may
not be higher than the benchmark. When thinking
about security selection, what's most important
is that there must be something that the
manager's doing that is hard to do. There must
be some frictions that prevent others from doing
the same thing.

short periods you may still underperform. I think
that's why most high active share managers
are not very patient about their stock picks.
My research suggests that it's the difficult combination of high active share with a patient
stock-selection strategy that has outperformed
the most-arguably because there are relatively
fewer managers who are able to do this.5

As a simple example, it's hard to be a patient
stock-picker in an impatient world. Even if
you're right about your long-term stock bets, over

5 Cremers, M. 2017.

90

Morningstar June/July 2018

Martijn Cremers

Ben Johnson, do the same issues of patience
during periods of poor performance apply
to index investors?

Johnson: There's a distinct set of expectations
when investors opt to index over selecting active

managers. The baseline expectation is earning
the benchmark return on that particular segment
of the market, less a modest fee.
Over the course of the past three years, I've done
a study similar to Mind the Gap, looking at
behavior gaps as they differ between actively
managed funds and index-tracking mutual
funds. Almost uniformly across categories, across
asset classes, the return gap is substantially
narrower in the case of index funds than it is for
active funds. I would attribute this in part to
differences in expectations. I would also attribute
it in part to differences in distribution.
Table of Contents for the Digital Edition of Morningstar Magazine - June/July 2018
