As some asset managers have fallen short of investors’ expectations, individual and institutional investors are asking themselves the same question, “are these fees worth the added benefit?” In this article, we will provide insight by comparing and contrasting traditional, long-only active and passive portfolio management.
Active and passive management are two broad-based styles of managing a pool of assets. Both styles see the same investment universe but in different ways. Active managers seek to return a risk-adjusted premium that outperforms their benchmark or tracking index. Generally, active equity and fixed income managers are compensated based upon a percentage of assets. On the flip side, active management requires more research and due diligence for exploiting market inefficiencies and purported above-average returns.
Active management fees for U.S. equity mandates benchmarked against the S&P 500 varied from 25 to 180 bps per annum (median fee was 51 bps <-- basis points, 100 basis points = 1% ). Active management fees for U.S. fixed income mandates benchmarked against the Barclays Capital U.S. Aggregate varied from 16 to 56 bps per annum (median fee was 26 bps). Security selection, sector allocation and the ability to generate alpha or risk-adjusted excess returns are reasons often cited for higher active fees
Passive management on the other hand is a manager’s approach to mimic a set of securities, such as an index. These managers are looking to generate a return and risk profile that resembles that of an index, regardless of how the individual securities perform. Investors are still charged a management fee; however, the fees are much lower (the median fee for both equity and fixed income managers is roughly the same, 8 bps). Fees are less because buying and selling of securities occurs less frequently, suggesting that there is less active involvement in security selection and monitoring.
Generally speaking, an efficient market is one in which prices of traded assets already reflect all known information about the particular instrument. Highly efficient markets or segments within an overall larger market are easier to passively track. Efficient Market Hypothesis postulates that active managers may not make recurring profits through trading because the market price reflects all information already, depending on the form of efficiency.
The large-cap space within the U.S. equity market is highly efficient, whereas the small- and mid-cap space is less efficient. Thus, inefficient or less covered markets and market segments present active managers with added opportunities to generate alpha (<-- excess return over the benchmark index, which the portfolio manager wants to beat)
