It’s not always easy being a cheerleader for active management.
Every week brings another flow report showing the ever-increasing market share of passives. Every quarter brings another Spiva report highlighting how many managers have failed to beat their benchmarks. And every year brings another obituary written by a well-heeled consultant predicting further mergers and general decline.
In the face of this almost relentless negativity, many asset managers have moved to shore up their market share by launching their own factor funds and shifting to a more index-centric model.
Touchstone Investments, however, has gone the other way, choosing to emphasize just how unlike the benchmark its managers are.
‘We pick the lane and our lane is what you call distinctly active investing,’ says Tim Paulin, senior vice president of investment research and product management at the firm. ‘You come to Touchstone and you know you’re going to get something very different from the benchmarks.’
Touchstone Investments is a Cincinnati, Ohio-based mutual fund shop that offers 39 funds, each subadvised by a single asset management firm, making for a combined total of $20 billion in assets under management. It’s Paulin’s job to find and monitor those subadvisors.
That may be his day job, but as a 30-year veteran of the investment industry, Paulin naturally spends a lot of time extolling the virtues of the managers he has picked, particularly in the face of difficult market trends for active management.
For those planning to ditch active for passive, Paulin has two things to say: Focusing on recent poor performance is dangerous, and only looking at the average manager means you miss the star performers.
‘Investors and many advisors have become more and more fixated on recent past performance rankings and ratings as primary selection criteria,’ he says. ‘Several studies show that selecting funds at the peak of their relative performance has not worked out well for investors, so there’s plenty of impetus to look for a better way.
‘Second, aggregate evaluations of what characteristics drive outperformance are largely missing the relevant point for investors evaluating individual funds. Naturally, if we lump together every active fund, we’ll find that expenses are a huge driver of performance differential. But what’s missed is that there are certain subsets of funds driving those results, such that focusing on characteristics that drive aggregate excess performance is not particularly useful when selecting individual funds.’
Paulin is not alone in banging this drum. The firm has teamed up with professor Martijn Cremers of Notre Dame University, one of the chief proponents of ‘active share’, to help spread the message about the benefits of active management.
While active share offers no guarantee of future outperformance, Cremer’s more recent work on managers’ skill, conviction and opportunity – what he describes as the three pillars of active management – is intended to help investors evaluate a fund’s potential performance. Touchstone has added some of its own proprietary research to Cremer’s work in a bid to educate investors.
‘We developed a concept we call SCOPE [skill, conviction, opportunity, patience and expenses] to help advisors and investors identify compelling characteristics of active managers that we believe set them up for future success,’ Paulin says.
SCOPING OUT TALENT
Paulin’s own framework for identifying top management talent is, understandably, more detailed (see box below).
One of his prerequisites for any manager hoping to win a mandate at Touchstone is that their strategy is not widely available elsewhere. This naturally leads Paulin to seek out lesser-known, smaller shops.
‘We won’t launch a fund unless we have some exclusivity,’ he says. ‘If you get in a situation where you launch a fund and then someone else launches the same fund with the same strategy five basis points cheaper, then you’re in trouble.’
Paulin’s team of 10 conducts research, selection and due diligence on the 18 third-party managers used in the firm’s funds. The team is made up of four units: manager research, product management, investment strategy and a single global investment strategist.
The research team consists of a director of research and two analysts reporting to him. In terms of coverage, each research analyst is responsible for 13 strategies and six shops.
Touchstone’s clients are split down the middle between institutions such as endowments and consultants, and retail, including broker-dealers and wirehouses.
PICK OF THE BUNCH
One manager that ticks the exclusivity and high active share boxes is Arlington, Virginia-based Sands Capital Management, which subadvises the $1.8 billion Touchstone Sands Capital Institutional Growth and the $2.4 billion Touchstone Sands Capital Select Growth funds, as well as the newer Sands Capital Emerging Markets Growth fund.
‘Because they’ve got 30 investment professionals running portfolios of 30 stocks, they know their companies really well. They’ve been applying their discipline for 27 years,’ Paulin says.
‘They’re really dedicated to applying their principles of investment and all of them are able to convey not only what they do, but why they do it, very well.’
Over 10 years to the end of November 2017, the Institutional Growth and the Select Growth funds are comfortably ahead of the average fund in the Citywire Large Cap Growth category, returning 165.8% and 151.3%, versus an average of 123.5%. The latter slightly lags the benchmark, the Russell 1000 Growth, which was up 156.3%.
Launched in 2000 and 2005 respectively, the Institutional Growth and Select Growth funds were closed to new investors in April 2013 against the backdrop of heavy inflows, as investors flocked to manager Frank M. Sands Jr’s strong performance.
However, the nature of highly concentrated portfolios means that their performance may differ starkly from their benchmarks and peers. While the Sands-managed funds ranked in the top quintile of Large Growth funds for each calendar year from 2009 to 2013, the subsequent three-year period from 2014 to 2016 brought severe underperformance. Such reversals can be extreme when they strike, but come with the territory for these concentrated strategies.
As a result of the outflows during this period, the funds were reopened to new investors in April 2016. New investors have been broadly rewarded too, with the funds enjoying a recovery in 2017, up 34.74% and 34.15% respectively to the end of 2017, ahead of the benchmark’s 30.2%.
‘The strategy benefited from deft stock positioning by the subadvisor, along with a nice tailwind for the market in general and the sectors the manager emphasizes. At some point, we knew that we would face the opposite – a period when emphasized sectors and industries are more challenged – compounded by individual stock detractors. And that’s exactly what happened starting in 2014,’ he says.
‘The funny thing is that there were some stocks in the portfolio that were performing poorly even during the good years for the fund. That’s why even great stock pickers don’t just pick one stock. But few investors spend much time decomposing what’s not working when fund results are stellar. As soon as underperformance takes hold, the second-guessing picks up. And poor performers, as Chipotle and Lending Club have been for Sands, can become a sore point that contributes to investors giving up on the strategy.’
The danger is that they do so at just the wrong time, he adds. ‘When so many of us seem to associate with the tenet “buy low, sell high”, why is it that investors tend to most urgently want to buy funds at the peak of their historical performance?’
A WATCHFUL EYE
Finding managers is only one part of Paulin’s job, with ongoing due diligence taking up much of his and his team’s time. On a quarterly basis, they hold conference calls with portfolio managers and analysts from each given strategy.
‘It basically comes down to what’s happening in the portfolio, how it's performing and if that matches with our expectations,’ he says.
Short-term dips are no cause for concern. ‘We’ve never had a situation where we’ve fired a manager because they went through a period of underperformance,’ Paulin says.
He adds that when the firm has terminated a subadvisor, it has always been due to a combination of poor performance, problems with process implementation and qualitative issues such as personnel changes.
He recalls a situation in 2010 when a manager underperformed significantly within the calendar year. Upon deeper research, Paulin discovered that the manager was going against his expressed process for falling stocks, selling when he should not have been.
‘You own a portfolio of stocks, the stocks are going to be influenced short-term by what the market does, and you don’t have to panic and make a decision very quickly that can lead you to make bad decisions,’ he says.
As 2018 gets underway, Paulin is adamant that a highly active approach is the right way to go – now more than ever – and argues that this is one of the worst times in history to keep chasing what has been hot.
‘There are times when bonds look expensive and there are times when stocks look expensive, but there are very few times when bonds and stocks look simultaneously as expensive as they do in the US,’ he says.
‘If you’re looking for growth, you can’t just go to cash and you can’t go to high quality bonds, so you’re going to have to take some risks. However, the question is: where are you going to take that risk?’
Paulin boils down his overarching analysis process to a single acronym – ‘SPIDIR’ – which is four parts qualitative and one part quantitative, he says.
The S stands for the stability of the fund management firm, and P is for personnel. The ID represents investment discipline, while the second I stands for the infrastructure of the firm, made up of its clients and operations, among other aspects. Finally, the R stands for results.
Before a manager is added to a fund, they are vetted and assessed by a hierarchy of senior-level Touchstone employees, including the head of institutional business development. Managers have to be approved by investment research, the product development committee and the product management committee.
‘We want to give the opportunity for everyone to ask any questions they have about operational, investment or compliance issues that might be relevant to successfully launching a strategy,’ Paulin says.