Calculate added value for clients considering shifting assets to index funds

Q

We are a long-only equity manager investing in U.S. small-cap stocks. While our performance has been above the benchmark over the long term, one of our clients believes they should move their assets into an index fund that replicates the Russell 2000. How can we demonstrate that our active management of this account has truly added value over time?

First, it would be important to understand exactly why they want to move toward indexing the assets you actively manage for them. If it is performance related, I'll deal with that shortly. But if it is associated with issues less tangible, more qualitative and less quantitative, then you should be aware of what these issues or negative perceptions are.

For instance, have you recently lost a key investment professional that raises some fear or doubts in their mind as to your ability to maintain the discipline and process you have evidenced in the past? Did you sell the firm or a portion of the firm to someone else that could affect the way the firm is run and might lead to a change in management style in general, the firm's culture and direction in the future or result in key personnel departures? Have you taken on a large amount of new assets and new clients that your client could perceive as a possible threat to your ability to manage the assets in the small-cap universe using your controlled and disciplined approach? Indeed, a large influx of new assets might force you to invest in larger companies than you were accustomed to merely because of size constraints. Were there any other substantive changes in the firm that would cause the client any anxiety over what the future might bring?

Assuming there are no extenuating circumstances, then ask them directly why they want to make this change. If the answer is performance, then you can really dig into the data and based on what you find, hopefully for you, make a strong case for active management in general, and for your management of the assets in particular.

So first, make sure you have calculated the net-after-fees, risk-adjusted rate of return of the portfolio for all single years the account has been under your management, as well as for multiple years, say three and five years, and for various up and down market cycles. Be able to demonstrate that the cash management that is part of your beta strategy has protected the client's assets in falling markets and has allowed you to take advantage of buying opportunities producing superior returns over various market cycles.

Demonstrate that your value added over the benchmark/index has come from your ability to find undervalued stocks, to run a more concentrated portfolio and has produced an attractive information ratio, and most importantly, has provided a fee-adjusted, risk-adjusted superior rate of return over the benchmark or index. If you can demonstrate this level of outperformance, then there is some other issue perhaps not quantitative in nature that is leading them down the indexing path. While long-only, traditional and active U.S. equity management has become an “endangered species” over the past 15 years, there is still room in any institutional equity portfolio for an active, U.S. small-cap manager with exceptional fee- and risk-adjusted returns over the long term. Good luck.

Frank Minard is managing partner of XT Capital Partners LLC, a sales and marketing specialist firm focused on raising assets from institutional investors on behalf of alternative asset managers. He worked for money management firms for more than 30 years, including at Bankers Trust, Morgan Stanley and Mitchell Hutchins Asset Management. He began his career as a pension fund executive, managing the AT&T pension plans.

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