Chasing performance by deviating from a benchmark has long been the hallmark of active managers. But it may be time for a rethink. Our research suggests that investors allocating to core equities should consider refreshing the criteria they use to identify portfolio managers that can consistently beat their benchmarks.
Active equity managers continue to face scrutiny. In concentrated markets, it’s become increasingly difficult to outperform because portfolios that diverge too far from index weights in the US mega-caps pay a heavy performance penalty. The mathematics of benchmark risk have raised high hurdles for stockpickers to generate alpha, or risk-adjusted excess returns versus an index. Volatile style rotations have created additional obstacles to reliable returns.
Shifting to passive is the popular solution. But despite the benefits of passive portfolios, we think active strategies still have a role to play in equity allocations. The challenge today is to identify managers that possess real active advantages and can help investors seeking more balanced return patterns through changing environments.
High Tracking Error Is a Red Herring
To do that, the first step is to take a critical look at classic measures of active investing. Tracking error (TE) is first up, because it’s widely seen as a badge of active investing effort. After all, TE is perhaps the easiest way to gauge whether an active manager is really doing their job by working hard on behalf of clients to invest independent of a benchmark.
Technically defined as the standard deviation of excess returns, TE measures a portfolio’s active return minus the return of its benchmark. In other words, it answers the question, “How closely does this fund follow its benchmark?”
The answer to that question is important, because asset owners don’t want to pay active management fees for a portfolio that hugs the benchmark (as many do). Yet although high TE theoretically creates opportunity for outperformance, it doesn’t tell you anything about the portfolio manager’s skill.
An Exercise in Active Manager Selection
In fact, our research shows that low relative risk managers delivered more consistent excess returns. Starting in 2013, we sorted managers by their TE and looked at their forward three-year relative return. We repeated this process through 2024 to capture 12 years of returns. We then randomly selected core equity managers within different TE quintiles, repeating the process 100 times. In the lowest TE quintile, 68% of managers outperformed (Display). In contrast, only 9% of the highest TE quintile managers beat their benchmarks. While that doesn’t mean every high TE manager is unskilled, it does mean that investors shouldn’t place too much emphasis on TE when choosing a manager.
