Entrusting an investment manager with financial assets is among the most important decisions any investor can make in their lifetime. Such a decision becomes even more critical when investors have long time horizons where consistent and healthy compound returns have the potential of altering the retirement pot significantly.
Given the wide range of options to active investment management, both locally and abroad, manager performance should merit careful and continuous analysis.
Very broadly, the main objective of active portfolio managers is to add value through the investment process so that they generate a rate of return which is higher than the return of a pre-defined benchmark portfolio. To provide some additional context, an active manager who invests in European large-cap equities would typically compare portfolio returns against the performance of the Eurostoxx 50 index.
During market downturns, active managers try to outperform the benchmark portfolio by allocating a higher weight to cash in an attempt to expose the portfolio to less downside. Passive investment strategies, on the other hand, replicate the returns of a benchmark index less any fees.
However, investors piling money into active funds should be prepared to pay significantly higher fees relative to passive funds or indexing strategies, given that in the case of the former, there is a highly specialised investment process with the aim of generating consistent excess returns.
The question should be whether the excess return (if any) is, at least, covering the elevated costs on an annual basis. The same concept also applies to portfolio managers who specialise in discretionary mandates. Therefore, it’s imperative that investors scrutinise the performance of active fund managers/discretionary portfolio managers to determine whether such management fees are, in fact, worth paying.
Passive investment strategies have experienced massive inflows over the past couple of decades, riding on their obvious benefits (diversified, simple and low-cost investment vehicles). The relatively low success rate of active fund managers in delivering on their promises of consistent ‘alpha’ proved to be another driving factor behind such flows.
According to the European Central Bank, over $4 trillion went into passive global equity funds over the 10-year period ending June 2024, whereas active equity funds saw outflows of $2 trillion throughout the same period.
Investors, in general, are risk-averse. They will surely require additional compensation for bearing a higher level of risk. However, it is very common for investors to focus on the absolute level of returns. The higher the level of such returns, the better, without any considerations to portfolio volatility.
Investors, in general, are risk-averse- Andrew Muscat
In practice, a more sensible approach should take into account both the risks and rewards. Furthermore, although it may appear that fund managers are beating benchmarks, a more thorough analysis of the risk-reward relationship would surely decipher additional insights.
The Sharpe ratio is one of the most commonly used metrics to measure risk-adjusted returns of a portfolio. By comparing the standard deviation (a statistical measure of both upside and downside volatility) of a portfolio over a given period of time against portfolio net returns in excess of the risk-free rate (typically, a government bond yield), one might conclude that the best performing portfolio manager is not necessarily the one with the highest absolute returns.
There are other variations to this ratio. The Sortino ratio considers the above; however, it focuses on the downside risks only, as upside volatility in market prices is a benefit to any long investor. The Treynor ratio, another risk-adjusted return metric, uses market risk, which cannot be diversified away, or ‘beta’, as the main measure of risk.
The bottom-line interpretation of these metrics is that the higher the ratio, the better the returns per one unit of risk, be it total risk, downside risk or market risk. Typically, these metrics will form the baseline of a peer-group comparison of active portfolio managers who follow a similar investment strategy.
In theory, the manager with a track record of high risk-adjusted returns, should be viewed as the outperformer.
Andrew Muscat is senior client manager at Curmi & Partners Ltd.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi & Partners Ltd is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.