Getting the Most Out of Active Management

Alec Lucas: Hi, I'm Alec Lucas with Morningstar's manager research team. I'm pleased to introduce Rob Lovelace of Capital Group and American Funds. He is a longtime member of the management committee and a longtime portfolio manager.

Rob, thanks for joining us.

Rob Lovelace: Thank you, Alec.

Lucas: I wanted to start off with the topic that you just addressed as a panelist here at our Morningstar Conference, and that is whether there's a case to be made for active management when investors are increasingly putting their resources into passive options. American participated in this discussion through their Active Advantage research. What role does active management play in general, and what role does Capital Group's American Funds have to play in particular?

Lovelace: Upstairs at the Morningstar panel, we actually took a straw poll, where I asked people in the audience whether they use active and passive. And the vast majority of people in the room raised their hands. So, really, what advisors and planners are doing now is using both active and passive. And everyone's goals are the same. We're trying to focus on making sure that people have the money in retirement and beyond that they need. It's about getting invested and staying invested. That's the challenge.

That "staying invested" part is critical, and I think it's where active managers probably bring the most value. It maybe isn't the thing that people think about initially, because it deals with volatility. Active managers tend to add the most value in down markets. Active managers tend to find those good companies that will do well; they tend to have cash in the portfolios. And so, in those challenging markets, they tend to do better. And that matters because people tend to get scared. They tend to get worried and move at exactly the wrong time--even investment professionals struggle with that sometimes. So, getting invested and staying invested is really, really critical.

There is also an understanding or a sense that active managers don't add value after fees. There is, demonstrably, a select group of active managers that add value over time. I've got some pretty easy ways of figuring out who that group of select managers includes; but in essence, those managers are able to add between 100 and 200 basis points over time, and that difference adds up over time. If you look at a 40-year period: For example, $10,000 invested in 1973, if you kept it in cash, today it would be worth about $70,000--so, '73 to the present. If you invested it in the index, it's much better--$550,000. So, this is the "get invested" part; just being in equities matters.

If you went with the select group of active managers, it's more like a million dollars. That's where the compounding impact of that 1% to 2% each year matters--and a difference of almost two times between the index and the select group of active managers. It's a big difference and has a big impact on retirement and retirement outcomes.

Lucas: And given that difference, maybe you could share what those screens are that you can use to find that select group of active managers?

Lovelace: Absolutely. Fees matter. We're all clear that lower fees are better because, over time, more of it is going back to results that help investors get the outcomes they want. So, focus on managers that have lower-quartile fees. A lot of active managers have fees as low as or lower than passive. That's another misunderstanding that I'm finding is out there in the market.

The second thing to do is look at track records, especially longer track records, but particularly downside capture. Focus on those active managers that do better in down markets. Again, those results are easy to find. Morningstar has good tools.

And the third, which is one that may be would be a surprise to some people, is to focus on those funds where the portfolio managers invest in their own funds at a substantial level. Morningstar's Russ Kinnel, I think, just put out a report on this where he focused at the fund level. We've done our own research at American Funds, looking at the fund-family level, and the research is really compelling. If you put those three pieces together, you can find a select group of active managers that do well over time--and it's that time factor that matters, but it works.

Lucas: So, low fees, strong track record, and then managers who invest in their own funds.

Lovelace: Yes. And that focus on volatility as a part of what their objective is, as active managers--

Lucas: That's part of the track record.

Lovelace: Yes, those three.

Lucas: American Funds has recently begun to target two different types of investors that you might say are on opposite ends of the spectrum--millennials, who are just entering their careers, and baby boomers, who have either just completed their careers or are about to complete them. What does American Funds have to offer these two very different types of investors?

Lovelace: I guess the way to think about it is that you've got two different phases for each of those groups. The millennials are in the accumulation phase. They're starting early, and I hear they're saving at a higher rate than the boomers did. So, that's great news. The millennials are saving periodically, and they're in the accumulation phase.

The baby boomers are starting to retire, so they're getting into the decumulation phase--that retirement-income phase. And we actually think that active management--[specifically] the way American Funds does it--has a particular offering to both. And it's the same things, which are lower volatility and predictability.

If you think about it, the big challenge in the accumulation phase is people getting scared and withdrawing at the wrong time or trying to time the market--being worried about whether they should be in the market right now. There are people asking me right now, "Shouldn't I wait to get in the market?" That dollar-cost averaging, consistently investing, and staying invested are so critical. When you have active managers that focus on volatility like American Funds, what it does is it helps you get invested and stay invested. So, we think that's particularly important for the millennials.

When you get into retirement, a lot of people focus on less equity and more fixed income for exactly that volatility reason. We're all clear that in retirement you can't afford to have even short periods of time where you have a substantial impairment to your investments. But what they forget about is longevity. People are living longer. That's great news. But if you plan and don't have enough in equity, you might not have the money you need when you get to be 80 or 90 years old. So, equity has a key role in that retirement savings, where the boomers are right now--more than they might have thought in the academic work before. But the equity managers you need have to be low volatility.

As I mentioned, you can't afford to lose money when you're at that stage, so you want low-volatility managers at that retirement-income phase. That's exactly where the active managers come in again. So, it's the same investment approach for both; it's attacking different reasons. But that's why we are appealing to both ends of the market.

Lucas: So, low volatility is key.

Lovelace: In both areas for different reasons.

Lucas: American Funds also has a long history of working with financial advisors. What role does advice have to play, and where does American Funds specifically fit in a world where you have self-directed IRAs, you have no-load options, you have fee-based advisors, and then you have the traditional commission-based advisors?

Lovelace: The challenge to investors is getting invested and staying invested. And staying invested is often challenged by fear, and the more we can create systems to help people through those periods when the market is down so that they can stay invested is really important. One aspect is volatility. Having less volatility matters, and active managers do better in that respect. But another one is having a financial advisor or planner involved--someone who you call and say, "I'm getting nervous about the market; I think we should sell everything." 

And they respond, "Now, remember, we bought these funds to be the core. We'll sell some of these other things so you'll feel better, but these are your core funds that you have to keep invested in. In fact, this is the time you should be putting more money in, not taking it out. Remember our plan." 

That's why American Funds is so dedicated to the advisor channel, working with planners in general, because that intermediary is so important. The reality, though, is that more and more people are using robo-advisors or other ways to invest. Those advisors aren't in the middle, and we're trying to do our best to figure out how to get them the advice to make sure they're thinking through the long-term strategies that they're going to need to be successful, because the enemy is that if they sell at the wrong time, they tend to be too late getting back into the market.

So, we're all trying to figure out how to do that; but advisors are a key part and make it a lot easier to save so that you have the money for retirement and through retirement.

Lucas: A theme of our conversation has been volatility, and a pretty volatile corner of the market is emerging markets. You've been a longtime manager on American Funds New World (NEWFX), which takes a very flexible approach to investing in emerging markets. Can you talk about where you see that fund and where you see the opportunities for investing in emerging markets in the current global environment?

Lovelace: I've been investing in emerging markets since the name was coined in 1986. And when we start at the beginning, this is a very volatile area, very challenging for people. And that volatility, again, it can be scary to people; it can get them in and out of markets at the wrong times. So, in the '90s, we were thinking about a way to create maybe a different approach to emerging markets--to get at the opportunity and have slightly less volatility to keep people in it and understanding it. And that's where New World Fund came from.

One of the cornerstones is that emerging markets themselves tend to be skewed toward mining companies--so, commodity-based companies--banks, and telephone companies. And if I asked you what you were most excited about investing in in an emerging market, it's probably not banks, telecoms, and commodity stocks. It's probably consumer products--rising standards of living. It's probably health care--again, better [quality of life]. It's probably technology--the brands that we all know. 

Those tend to be multinational companies that are based in other countries that sell their products there. So, we thought why not really focus on the emerging-markets opportunity, both infrastructure improvement and rising living standards, and give the investor an opportunity to capture that--multinational companies combined with the companies in those countries. And in so doing, it gives you more liquidity and less volatility. So, to us, it's kind of the perfect package.

Lucas: Rob, thanks for joining us and thanks for sharing your insights.

Lovelace: Thank you.

Lucas: For Morningstar, I'm Alec Lucas.