Equity

Choosing the right active investment managers

Mar 06, 2024|ByCarolyn Barnette

Key takeaways

High market dispersion gives active managers the chance to pick the right securities to drive outperformance, but it’s up to you to pick the right active managers.
Look for active managers with consistent rolling performance and make sure the funds you invest in serve the purpose you intended.
Diversify your active managers, but don’t overdo it. Give the managers you choose enough weight in your portfolio to drive outcomes.

High market dispersion creates alpha opportunities

Stock market dispersion – the gap in performance between winners and losers – has risen significantly in the post-COVID age. Some of the biggest winners of 2023 are still winning in 2024 – Nvidia (NVDA) was up 58% YTD through Feb 22^nd – while 215 of the stocks in the S&P 500 are down. With dispersion this high, many investors, including our own BlackRock Investment Institute, are making the call that this could be a great time for top active managers.

Stock dispersion is elevated in the post-COVID era
Average annual total return difference between top half and bottom half of MSCI ACWI Index (%)

Source: BlackRock, with data from FactSet as of 12/31/2023. Annual stock dispersion is calculated by taking the average total return of the top half performers of the MSCI ACWI Index (above or equal to the median) and subtracting the average of the bottom half. The stock dispersion chart shows the average of the annual dispersion observations across each period. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

The greater the dispersion, the greater the potential opportunity for skilled managers to generate alpha. But there’s no free lunch. For every buyer, there’s a seller, which means every time an active manager makes the right call, another gets it wrong.

Dispersion has benefited skilled managers
Alpha generated by 25^th and 75^th percentile developed market equity active managers

Source: BlackRock Investment Institute, January 2024. Alpha defined by Morningstar as the difference between an investment’s expected returns based on its beta and its actual returns. A positive alpha indicates the investment has performed better than its beta would predict. A negative alpha indicates an investment has underperformed, given the investment's beta. The charts show the difference between the top quartile (top 25% rank) and bottom quartile (bottom 25% ) of alpha generated by alpha-seeking managers across developed market equities. Years of ‘high dispersion’ are highlighted when the difference between the average return of top and bottom quartile stocks in the MSCI World Index is 70% or higher.

If you want to capitalize on high market dispersion, you need to pick the right active managers – and get the size of your allocations right, too. Consider these four rules of thumb:

1. Look under the hood: process is key

The first step to assessing an active fund is to make sure the manager’s process gives you the exposures you’re looking for and the potential for alpha that’s worth paying for. You likely don’t want a manager you hired for growth exposure picking out value stocks, or a manager you hired for U.S. exposure inadvertently increasing your allocation to EM stocks. That said, we have historically found that fund policies that give managers more flexibility – or a wider pool to fish in – have provided a greater ability to drive alpha, but you still have to make sure you’re comfortable with the exposures you’re getting.

Next, make sure the manager’s process justifies the fee. Market exposures can be replicated cheaply and easily with indexes, but security selection and dynamic market timing cannot. When you compare the fund to a relevant benchmark, how different is the performance, and what’s making it different? Is it driven by market beta? Static factor exposures? Or is it idiosyncratic returns? Use your data services to decompose fund returns or ask the fund manager to explain their process for driving alpha.

Don’t pay active prices for passive investments. The manager’s process has to be worth the fee. For example, the BlackRock Unconstrained Equity Fund (MAEGX) has delivered top decile performance since inception of the strategy in March 2022 by navigating through volatile markets with a high-conviction portfolio of 22 names.
(Source: Morningstar as of 4/30/24. PM inception as of 3/1/2022. Morningstar category is defined as Global Large-Stock Growth, and MAEGX is ranked 7th out of 318 funds in the category. Rankings are based on total return excluding sales charges, independently calculated and not combined to create an overall ranking.)

^{2. Ensure the fund fits your purpose}

Think about the reason you are investing in the fund. In the case of equities, it’s generally to drive alpha above a benchmark. But in the case of bonds, or alternatives, you are likely also seeking a diversification component.

Resist the urge to simply hire the top-performing bond or alternatives manager in the category. There’s a good chance that their stronger outperformance is driven by higher risk and/or a higher correlation to equities than you’re comfortable with. If equity diversification is important to you, screen for correlations first. Once you have your universe of funds that have acceptably low correlations, then look for attractive risk-adjusted performance.

Skilled active managers have the ability to provide both diversification and attractive returns. The BlackRock Global Equity Market Neutral Fund (BDMIX) delivered a 14.6% return in 2023, well above its Morningstar category average return of 5.1%. Perhaps as important, though, is that it delivered that return with a correlation of 0.07 to the S&P 500.
(Source: Morningstar as of 12/31/23. Morningstar category is defined as the Equity Market Neutral category.)

Performance data quoted represents past performance and is no guarantee of future results. Investment returns and principal values may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. All returns assume reinvestment of dividends and capital gains. Current performance may be lower or higher than that shown. Refer to blackrock.com for most recent month-end performance.

^{3. Check for consistency: rolling performance means more than snapshots in time}

It’s really hard to beat an index. In fact, most managers don’t. After accounting for their fees, 86% of U.S. large cap managers underperformed the S&P 500 over the last 10 years.¹ Outperforming on an after-tax basis is even harder: 96% of U.S. large cap managers underperformed the iShares Core S&P 500 ETF (IVV), 88% of mid cap managers underperformed the iShares Core MidCap 400 ETF (IJH), and 95% of small cap managers underperformed the iShares Core SmallCap 600 ETF (IJR) on a total return basis after taxes over the past ten years.(Source: Morningstar as of 12/31/23. Based on 897 large cap, 241 mid cap, and 391 small cap ETFs and mutual funds with 10-year track records in the Large Blend, Mid-Cap Blend, and Small-Cap blend categories. Total return represents changes to the NAV and accounts for distributions from the funds (excluding any applicable sales charges). After-tax return assumes distributions are taxed at the highest federal tax-rate prevailing for each type of distribution, and that after-tax proceeds from those distributions are reinvested. It assumes fund shares have not been sold (pre-liquidation). The calculation does not reflect the tax effects of the alternative minimum tax, exemptions, phase-out credits, or any individual-specific issues. State and local taxes are ignored.)

Still, there are active managers that do outperform, although many don’t outperform consistently. The S&P U.S. Persistence Scorecard found that just 37% of above-median large cap managers in one five-year period remained in the top half in the following five-year period.² Don’t get swept away by one really good performance period (or discouraged by a bad one). Instead, look at rolling performance periods to get a better sense of a manager’s consistency over time.

The BlackRock Strategic Income Opportunities Fund (BSIIX) has beaten the Bloomberg Aggregate Bond Index by over 1%/year since its strategy inception in 2010.³ The fund aims to drive alpha via active duration positioning and security selection. A notable example of how the strategy has added value was the manager’s decision to maintain a low duration through 2021 and 2022, which drove strong performance when the Fed began hiking rates.

Our Investment Quality (IQ) tool, which is available for financial professional use only, can help you evaluate a fund’s performance. Use it to see rolling three-year returns and the percentage of time a fund spends in the top, bottom, and middle quartiles relative to peers.

Keep your expectations in check. It isn’t realistic for a fund manager to win every time. 98.7% of equity mutual fund managers with a top quartile 10-year performance record spent at least one three-year period in the bottom half of their peer group.⁴

It’s unfortunately common for investors to give up on great funds at exactly the wrong time. The average investor’s portfolio has tended to underperform the fund they invested in due to their buying and selling the fund at the wrong times. It’s certainly understandable – three years is a long time to maintain faith in an underperforming fund, and of course, there are plenty of underperformers that don’t end up with top quartile 10-year returns. If you don’t have high enough conviction to stay with an active manager through spells of underperformance, you’re likely better off just owning the index.

Be patient or be passive: investors who sell underperforming funds often underperform them
Difference between average investor and fund returns, 10 years annualized through 12/31/22

Source: Morningstar “Mind the Gap 2023” report as of 7/31/2023. Data as of 12/31/22, based on time-weighted vs. dollar-weighted return calculations done by Morningstar for each fund within the defined Morningstar categories. Average investor defined by Morningstar and estimates the average return earned collectively by all the investors in a fund. Investor return, also known as dollar-weighted return, accounts for all cash inflows and outflows from purchases and sales and the growth in fund assets. It complements the more traditional metric of total return, which measures what investors could have earned had they bought and held the fund, reinvesting all dividends, over a period of time.

4. Diversify, but don’t overdo it

After all the effort you’ve put into choosing an active manager, give the investment enough weight in your portfolio to have an impact on portfolio outcomes. If you overdiversify, you may lose the ability to capitalize on your chosen active manager’s ability to drive portfolio alpha.

Additionally, avoid hiring too many active managers in the same space. If they take opposite bets, you may end up overpaying for a portfolio that looks a lot like the index. For example, if you invested in a large cap growth active manager who is overweight technology and a large cap value active manager who is underweight technology, you might end up back at neutral. You’ll be paying fees to each of the active managers but you’ll be unable to capitalize on either of them making the right call.

By definition, high conviction active managers make big bets – and those big bets can pay off in a big way when they’re right. But markets are notoriously difficult to time, so it’s important to buffer your portfolio against individual managers underperforming in the short term. Consider building a core of low-cost index exposures to ensure you participate in benchmark performance, while using active managers to seek alpha.

To find your optimal mix of index and active exposures, look at the tracking error, or active risk, of your portfolio to see how much it differs from your benchmark. If your tracking error is too high, you risk underperforming meaningfully if your managers’ market calls are wrong (such as being underweight technology in 2023). If it’s too low, you risk underperforming after fees – or at the very least, wasting your time and energy researching active funds.

Use our 360 Evaluator to analyze the tracking error of your portfolio vs. your selected benchmark. You can also use the IQ tool to see the tracking error of each individual fund you hold versus its own benchmark. Together, these tools can help make sure that each fund is meaningfully different from the benchmark, and that the combination of funds are active enough to achieve your goals.

Next steps

There is a lot to be excited about in the actively managed space, but it is critical to get your manager selection right and size it appropriately. BlackRock can help you construct well-diversified portfolios for your clients. Contact your BlackRock representative for more information or explore our online investment tools and resources.

Explore the Advisor Outlook – BlackRock’s monthly market outlook for financial advisors – for more details on our latest market and portfolio insights.

Advisor Outlook

Performance data quoted represents past performance and is no guarantee of future results. Investment returns and principal values may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. All returns assume reinvestment of dividends and capital gains. Current performance may be lower or higher than that shown. Refer to blackrock.com for most recent month-end performance.