There has been much debate of late about the benefits and shortfalls of active vs. passive portfolio management. This article will not highlight the benefits of either argument, but instead highlight what investors should look for in a truly active managed fund. One key point is that many fund managers who market themselves as active, and thus have a higher fee structure, do not do themselves and their peers any favours as their underlying portfolios are much more inclined to that of their passive counterparts. Investors should consider the following when looking for genuine exposure to an actively managed product.

1. How many individual stock positions does the portfolio hold?

Many investors believe that that the more stocks that a portfolio holds, the lower the level of risk within the portfolio due to increased diversification. While this may be true, the effect on return is that, over time, you will achieve a return that is very close to that of the equity index in which the portfolio is invested in. More investors need to focus on risk as well as return.

Studies have shown that to achieve a balance of risk and return, the ideal number of holdings is between 10-20 individual positions. The challenge for fund managers is that it increases the pressure on the investment process and philosophy, as any significant price movements are magnified both up and down.

2. Can the portfolio hold a significant amount of cash?

The terms defensive stocks and cyclical stocks are often in fashion when the macro environment dictates what a portfolio manager holds. However, if a market is overvalued, often the best hedge for any investor is cash, and not a defensive set of stocks. There is little advantage is owning a stock that goes down less than its peers if it still produces a negative absolute return.

3. Is the portfolio benchmarked to an equity index?

Many investors would want and have exposure to active funds benchmarked to the ASX 200. Approximately 38% of the ASX 200 is within the Big Four banks, Telstra, BHP and RIO. This quite often means that any active manager that is benchmarked to the ASX 200 will likely have 30-45% of their portfolio within these seven stocks, regardless of whether or not their research suggests that these stocks would provide a positive absolute return over the next one to three years.

For any manager that is benchmarked to an equity index, is it a respectable result for them to be down -5% if the benchmark is down -8%. Could this return have been better for investors if the portfolio manager was not as focused on index returns? To highlight this point further, Telstra was circa 4% of the ASX 200 index in July 2015, and has returned negative -24% before dividends since then. It cannot be said that an ‘active’ manager who was underweight Telstra, but still owned the stock, has truly outperformed.

4. Are the Funds under Management (FUM) ideal for the portfolio’s investment universe?

Finally, fund managers are often victims of their own success. If their respective funds generate superior risk-adjusted returns, this often leads to increased investor awareness and capital inflows from new investors. This increased FUM profile can place a significant amount of strain on the investment management team and the investment process that proved so successful previously.

A fund that was invested $100 million in small companies can often be running $500 million to even $1 billion within the same investment universe. What this often leads to is the necessity to hold more liquid positions (larger companies) which are often more efficiently priced, and also hold a greater number of positions which can lead to lower quality investments. The outcome of this is often overall lower performance to that of when the fund size was small and more appropriately sized for the desired investment universe.

It is true that an actively managed portfolio will not be for every investor, but a product with the right structure and attributes, together with a long-term investment horizon, can lead to significant outperformance over time.

Thank you for reading.

Written by Sebastian Evans, contributed by NAOS Asset Management

Disclosure: The two listed investment companies (‘LIC’s’) that Naos Asset Management manage, being the Naos Emerging Opportunities Company (ASX: NCC) and the Naos Absolute Opportunities Company Limited (ASX: NAC), both hold less than 20 stocks each and can have cash weightings of up to 100%.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.