Unpopular active managers

Actively managed funds, including SKAGEN's funds, have struggled against their benchmark indices since the autumn of 2008 and the financial crisis. This is small comfort for our unit holders who have selected SKAGEN because our business concept is built on the premise that the equity funds should beat the index over time.

While the companies included in the indices have seen their price tags steadily rise, the pricing in our portfolios has not increased markedly, even though the absolute return has been good in the period. US equities in particular, as well as companies with stable earnings and high dividend yields for shareholders, have re-rated.

We have seen this before. From SKAGEN's active perspective, this can best be illustrated by developments at the end of the 1990s when index-heavy companies like Pfizer and Microsoft were priced at 50-60 times earnings (P/E 50-60x). These companies turned out to be the losing companies on the stock market in the decade that followed, and became increasingly unpopular amongst investors. This was in spite of the fact that they had been earning good money over all these years. In other words, the pricing was subject to a substantial devaluation.

When the companies became unpopular enough and their earnings multiples had dropped to one-digit levels, SKAGEN Global bought holdings in both Pfizer and Microsoft, and both companies have delivered good returns to our unit holders. When the P/E level of Pfizer doubled, we exited the holding. Meanwhile, Microsoft continues to have a place in our portfolio as expected earnings will likely be adjusted upwards going forward.

Value wins in the end

At present the pricing of the most popular and index-heavy companies is nowhere near the level we saw in the 1990s, but the P/E levels are well above historic average. What is expensive today may of course become even more expensive tomorrow as it is difficult to stop a flock of sheep once it has gathered momentum.

Nonetheless we still believe that value will win in the end. We also believe that active value managers, who are not just active on paper but have more than 90 percent of their portfolio in stocks that are not included in the index, can deliver good absolute and relative returns over the coming years. The prerequisite is that the companies are priced at a large discount to the index, as is the case with those in our equity funds.

Swimming against the tide

"Experience has shown that it is better for one's reputation to fail traditionally than to succeed untraditionally," said the well-known economist and active value manager, John Maynard Keynes.

The job of an actively managed, value-based fund – such as those managed by SKAGEN – is, in short, to outperform its benchmark index. In order to do so, the fund manager must construct a portfolio that differs from that of the benchmark.

How far a manager is willing to deviate from the index is what is known as 'active share'. A figure of zero percent means the fund is identical to the benchmark index. An active share of 100 percent, on the other hand, means that the fund has virtually no overlap with the index. As illustrated in the graph, the active share of funds varies materially.

Funds with a low active share – commonly known as closet index funds – cannot really justify having a high management fee. The likelihood of their returns exceeding those of the index after fees is very low.

Let us take an example of a fund that charges a one percent management fee and has twenty percent active share. If the active part of the portfolio delivers a respectable three percent outperformance, the fund as a whole would underperform the benchmark by 0.4 percentage points.

Indeed, a very strong outperformance figure of 5% would be needed in the 20% active portion simply for the fund as a whole to beat the index. It is easy to see how the performance figures simply cannot add up for so-called closet indexers who operate under an active label but essentially shadow the index.

Those who wait should be rewarded

A 2010 study[1] of 1,124 active funds showed that the majority of funds, not surprisingly, underperformed their respective benchmarks by an average of 0.41 percentage points net of fees each year between 1990 and 2009.

For funds with an active share below 60 percent – tagged by the study as closet indexers – the outcome was a dismal annual underperformance on a net return basis of minus 0.91 percentage points during the period.

The 180 funds with the highest active share, however, actually outperformed their indices by an average 1.26 percentage points per year net of fees over the same period.

By way of illustration, SKAGEN's global equity funds have an active share of over 90%, clearly putting us amongst those that deviate most from the benchmark. This makes us very well positioned to create added value for our clients in the future.

[1] Antti Petajisto of NYU Stern Business School on US Equity Mutual Funds