By Daniel Archibald | CFA
There exists an ongoing debate between active equity portfolio management and passive management, with evidence showing that many fund managers regularly underperform their respective benchmarks, after accounting for fees. One thing often overlooked in such analyses is the additional risk awareness that accompanies active management, though incorporating risk measures into performance evaluation can be tricky.
Whilst a passive equity portfolio can eliminate the need for costly research, there are still plenty of active managers that are able to consistently make up for this added cost through excess returns. To do so, equity fund managers look to employ a number of different tactics, tilts and styles. These include:
- Value seeking
This type of manager might be like your bargain hunter at the second-hand store - on the hunt for treasures that others have overlooked. As most value managers will attest, cheap doesn't always mean value, and these investors will be cautious of not falling for so called 'value traps' - Growth orientated
Looking for the next 'big thing' is this manager's mandate. This might be those businesses at the forefront of technological disruption or others that are naturally blessed to be in the right place at the right time. Of course, growth managers can also fall into their own traps, especially in betting big on false potential - Quality only
What about companies that are not undervalued and not looking at double digit earnings growth. This is where quality managers play, looking for companies that have strong and stable cashflows, and which are usually protected by some sort of natural defenses from pesky competition. Quality, however, can be heavily affected by unforeseen disruptions to business models and economic environment - Income hungry
Some managers may want to simply focus on companies that offer a relatively high dividend. This can be due to liquidity needs, tax-friendly franking credits or a conviction that managers that distribute money back to shareholders are more likely to be thrifty with the cash they retain. As equity prices rise, income yields can fall, making it difficult to find appropriate opportunities for investors - Derivatives overlay
One form of income production available to equity investors may be from option writing. This may be from 'buy-write' strategies where managers earn income by offering purchase rights over portfolio holdings or from 'write-to-buy' strategies where managers offer to buy desired stocks. Both of these strategies work well if stock prices remain stable or even fall, but this is at the expense of cashing in on fast rising prices - Short mandates
Derivatives can also offer portfolios downside protection through short positions (borrowed holdings) in equity index futures. Other short strategies might be employed by managers who might seek to not only earn returns from rising prices of long exposures, but also from falling prices of short exposures (either in an absolute or relative sense) - Smaller companies
Managers might also look to earn additional returns by heading to the smaller end of the market. The smaller the company, the lower the number of analysts digging through its financials and company details. This can lead to more opportunities for mispricings and mis-categorisations - the bedrock of active management - Emerging markets
Equity managers may also seek excess returns by heading to far flung and less researched parts of the world. Emerging and frontier market economies are likely to grow, on average, at higher rates than their developed market counterparts. Investors might also expect investment returns to exhibit a similar bias - Private equity
Some equity managers shun public markets all together, looking for diamonds in the rough in the unlisted space. These are likely to be very small companies (e.g. less than $100M in revenue), and may include venture capital type companies with high growth potentials (i.e. still in start-up or early expansion phases) - Sector rotation
Another trick up the equity managers sleeve is to apply a top-down approach to finding equity opportunities. This might include sector rotation specialists that look to assess the broader economy to find industries likely to thrive in the medium term. This allows for the shifting of allocations between industries based on expected performance - Event driven
Managers might also seek additional returns by looking at other external factors. This might be taking advantage of pricing discrepancies that are common when companies are involved in mergers and acquisitions. Or it might be based on the sharp price movements that can accompany index re-weightings, ex-dividend timings or risk of insolvency