Q:  What is the Active Share concept? A : Active Share was first coined by a pair of Yale professors in their landmark paper How Active Is Your Fund Manager? A New Measure That Predicts Performance published in March 2009. In their 23 year study Martin Cremers and Antti Petajisto discovered that “so called” actively managed funds that closely resemble their respective benchmark tend to underperform that benchmark and, conversely, those funds that were markedly different from their benchmark tended to outperform. They created a metric they call “Active Share” – a measure of the percentage of stock holdings and weights of those holdings in a manager’s portfolio that differs from its respective benchmark. The wider the difference the greater the Active Share. In fact, the study discovered that those funds that had the highest Active Share significantly outperformed the benchmark index. The original study focused on the period between 1990 and 2003 and then the study was updated with returns through 2009. The studies revealed that those funds in the highest Active Share quintile outperformed their counterparts by 140 basis points annually, net of fees. Conversely, those funds in the lowest Active Share quartile underperformed by 140 basis points. Interestingly, these professors observed that the percentage of assets in U.S. equity mutual funds with an Active Share of 80% or higher (that is, funds that are truly different from the benchmark) declined precipitously over the last 3 decades. In the early eighties, close to 70% of fund assets were represented by funds with an Active Share of 80% or higher. By the end of the 2000s, that ratio declined to less than 20%. Q:  Why do you think that the degree of assets that are represented by high Active Share funds declined so dramatically? A : That's a really important question because it illustrates how the industry has really changed over the last three decades. It all began with the advent of style boxes and the creation of indices designed to complement those style boxes. The nine grid style boxes were first introduced in the early nineties. Prior to that period, many funds were managed against broad market mandates like the S&P 500 index or the Dow Jones Industrial Average. In fact, prior to the introduction of the style boxes, risk or standard deviation was typically measured against those broad markets. But that all changed when the style boxes were introduced. Before the introduction of style boxes, most asset allocation models featured 4 to 5 asset categories – equities (typically large cap equities), bonds, cash and sometimes international equity. Style box methodology effectively redefined how investors thought about asset allocation models by sub-dividing the broad equity sleeve into nine sub-categories. This innovation was nothing less than a sea change for the money management industry. Investors began demanding mutual funds that represented those style boxes. Concepts such as style drift (a fund’s tendency to drift from one style box to another) and tracking error (a returns based measure of the difference between a portfolio and the benchmark) became critical selection criteria as investors needed to be assured that the underlying funds in their models were representative of the style box and did not overlap with other funds in other style boxes. New indices were also developed during this period like the Russell 2000 Value and the S&P 400 Mid Cap Index to address this demand for more refined benchmarks. In turn, fund managers began implementing “risk control” measures to ensure that they stayed true to their respective style box. Low tracking error, minimal style drift and high R2 were measures that were implemented by many fund managers to address this new demand. In many ways, the penalty for style drift was far greater than under-performance. As a result, fund portfolios tended to closely track their respective benchmarks with “bets” (e,g., differences) being made on the margin. I recall a conversation I had with a mid-cap value money manager during these early days. He was frustrated that he was forced to own REITS even though he believed that they were a poor investment at the time. REITS represented over 20% of the benchmark and he believed that they would be a drag on his overall fund performance. The problem was that by not owning REITS he ran the risk of diverging too far from the benchmark which would not have been tolerated by investors. That, in a nutshell, represents the deleterious effects the style box methodology has had on the asset management industry. Eventually, mutual funds became the default vehicle for investors to gain access to an asset class, not necessarily outperform. Essentially, their job was to mimic the benchmark/style box and deliver enough performance to offset their fees. The result is an industry that has experienced significant asset growth in funds that are effectively “closet indexers” and a shrinking proportion of truly active funds. Q:  How has the institutional investing marketplace adjusted to this? A : We believe closet indexing naturally led to questions among institutional (and non-institutional) investors as to why they should pay active management fees for benchmark-like positioning and benchmark-like performance – or worse. Passive investing has become commonplace as a portion - or a majority even - of some institutional, advisor and investor portfolios. However, the market is quite diverse and, as such, there is room for a variety of money management styles and approaches. Today, we are seeing increasing focus on high conviction, high Active Share, stock pickers to ensure active management fees are accompanied by benchmark-differentiated strategies. These managers are hired for their ability to out-perform their benchmarks, not mimic them. We see this trend leading to increasing market share for the extremes of the Active Share spectrum – continued interest in low cost, passive investments and increasing focus on the most highly active segment of active managers. Q:  So, if a manager has high Active Share are they better than low Active Share managers by definition? Not necessarily, high Active Share merely conveys that the portfolio holdings and holding weights are greatly different from the benchmark. But one thing is certain. It is virtually impossible for a low Active Share manager to beat the benchmark because, they approximate the benchmarks holdings – but with higher fees than purely passive vehicles. Essentially, a high Active Share metric means that that manager has the potential to outperform its benchmark. A :Q:  You have a chance of outperforming or under-performing? A : That's right. Just knowing that you’re different from a benchmark only means that you have the chance. Then one needs to examine what goes on behind the curtains. Does this manager have the experience, credentials, and technical wherewithal to out-perform (talent, systems, approach)? Have they demonstrated that ability over time? That is essentially what Touchstone’s investment research analysts attempt to discern. We hire managers who are steeped in managing high conviction strategies over long periods of time. For example, one of our sub-advisors is Sands Capital Management of Arlington, Virginia. Sands has been running large cap growth portfolios for more than 30 years. They are a high conviction, high Active Share manager. They know their stock holdings inside and out. Their large cap growth portfolio generally holds around 30 stocks. They have 25 analysts covering those stocks. Those analysts examine all aspects of a company as well as its competitors, customers, suppliers, etc. High conviction and being different from the benchmark is not a new approach for Sands Capital. They have been doing it since their inception over 30 years ago. The challenge for retail mutual fund managers is that they have spent the last 20 years mimicking the benchmark with large, diversified portfolios. They’ve been trained to manage portfolios within a very controlled framework. If they do not address the ETF threat they run the risk of extinction. For many, transitioning to a high conviction, high Active Share portfolio will be challenging. For some, migrating massive asset bases to more concentrated, highly differentiated portfolios will be virtually impossible due to liquidity constraints. Q. What did style purity offer? Q:  What happened to absolute return investing? A : The simplest way to think about what “absolute return” investing used to be is “I’m just trying to make money for my clients”. Note that does not end with the phrase “by investing in the best companies with market capitalization below $2 billion and P/E below 15.” Investors like Peter Lynch and Warren Buffett tried to discover the best companies they could find and then focused their investments in relatively few of those businesses. That didn’t mean that they were trying to make money despite what happened in the market. At that time, hedge funds were not the more mainstream investments they have become today – and they certainly did not exist in mutual fund form. That form of “absolute investing” was replaced by the need to provide asset allocators with style pure investment options. That is, until the Great Correction of 2008. In 2008 investors discovered that asset classes were more correlated than they thought. The protection they sought from asset class diversification did not materialize. At its simplest form, stock/bond diversification worked wonderfully in 2008. But even many bond investors had corrupted their allocations by loading up on exposures that were heavily correlated with equities. As a result, everything went in the same direction at the same time in a crisis. As such, the global financial crisis led to a re-examination by institutions and advisors regarding asset allocation techniques and investment constraints. There is recognition that segregating value from growth, large from small and U.S. from non-U.S. is not an effective means of managing risk when you really need it. Such distinctions are becoming thought of more as elements of the investment “opportunity set” rather than for their correlation benefits in an asset allocation plan. Yet the core asset allocation decision among stocks, bonds, cash – and now alternatives, too - remains a vital decision for investors. Within those broad classes, investors often remain focused on simply finding exposure and the breadth of passive vehicles makes exposure easy and cheap to implement. Selection of active managers is, we believe, just starting to evolve. The new form of absolute return investing is appearing in the form of hedged and unconstrained mandates where the manager is no longer wed to his/her style box but rather has free rein to invest where the best opportunities exist. A good example of these unconstrained funds is the popularity of global tactical asset allocation funds run by firms such as Blackrock and Ivy Asset Management. Recent flows to long/short equity funds also indicates interest in broader mandates. But many traditional, long-only equity mutual funds are not in a position to evolve their portfolios to meet the changing needs of investors. Some are just too big to change. Others lack the competencies, depth and experience among their investment professionals. As a result, the closet indexers that were deemed fine options for style pure exposure are now in survival mode – “how can we hang on to what we have for as long as possible?” Institutions and advisors are more and more focused on the qualities most associated with specialist, institutional asset managers – more concentrated, high conviction, highly active strategies. It's a new world. Passive investing and ETFs have revolutionized the business because now it's efficient to buy an ETF in a particular asset class if you are an asset allocator simply looking for exposure. The only way to compete in the new world for active management is to be a talented, high conviction manager. Q:  So, Touchstone has carved out a definitive niche by employing highly active managers that are completely different from the index. A : Exactly right. But you can’t stop there. Finding the right managers who are different from the index takes effort, discipline and resources. And, even then, successful investing takes patience. The desire for immediate gratification and the tendency to focus solely on recent results in making investment decisions have severely hampered investor results – for both institutions and individual investors. Sticking with a strategy in difficult environments is paramount to long-term success – whether the investments be passive or active. Q:  Can you discuss some of your high conviction managers? A : Sure. Fort Washington Investment Advisors of Cincinnati, Ohio is the sub-advisor for the Touchstone Focused Fund. This fund had an Active Share of 90% as of March 31, 2014. The manager emphasizes the importance of combining a disciplined investment process with a concentrated portfolio. They believe that portfolio concentration ensures that they only own the companies where they have the highest level of conviction. The portfolio typically holds between 25 and 35 stocks. The portfolio manager is an advocate of fundamental investment philosophy and manages a portfolio that includes stocks that have strong economic moats that sell at a significant discount to intrinsic value. The London Company of Richmond, Virginia is another good example. The London Company was founded in the early 1990s and manages equity strategies across the capitalization spectrum from small to large cap. They sub-advise both the Touchstone Small Cap Core Fund and the Touchstone Mid Cap Fund. Each strategy has Active Share in excess of 95% and fewer than 40 stocks in the portfolio. And the firm’s history in managing small cap stocks institutionally goes back to 1999. Q:  What is outstanding performance? A : We focus on two critical elements to determine what outstanding performance is for a particular strategy – an appropriate time horizon and rational expectations of when the strategy will experience headwinds and tailwinds. In that manner, we can gauge whether short-term outperformance or underperformance is consistent with what the strategy should produce. Candidly, we would get just as worried about a manager that’s doing well in a period when they should do poorly as a manager doing poorly in a period when they should do well. That would be an indication that we don’t understand something about the strategy. With that background, outstanding performance is one that beats relevant benchmarks over a reasonable time horizon and performs as we expect during the ups and downs that naturally occur from quarter to quarter and year to year. Think about 2008. In a year like that, we expected our large cap growth strategy managed by Sands Capital to underperform an index like the S&P 500. It’s what they have done in up markets that created the long-term returns that rewarded investors. On the other hand, managers like The London Company have delivered their greatest benefits in periods where markets are down. I have to reiterate a point I made earlier here: when you're investing with any high conviction manager, you need to be willing to weather some periods of underperformance relative to a benchmark on a short-term basis because these managers have a longer term horizon. They are not focusing on how to look or act like the benchmark from quarter to quarter. Their time horizons are much longer recognizing that buying a company that appears attractive today will require patience while other investors recognize the opportunity. The horizon for many of Touchstone’s sub-advisors is three-to-five years and even longer in some cases. Q:  Do all of your funds have a high Active Share? A : At Touchstone, we have 34 funds, but the Active Share metric only pertains to equity funds. It doesn't pertain to fixed-income. We have 19 all equity funds, and all but 3 have an Active Share above 80%; our lowest Active Share fund has an Active Share of 73% (as of March 31, 2014). All of our funds are sub-advised by institutional asset managers as we don't run any money in-house at Touchstone. That means we can virtually assure that our equity funds are high conviction, high Active Share strategies because we incorporate the metric into our research process in identifying and monitoring our sub-advisors. Q:  How do you go about evaluating and selecting managers? A : We have a research and product team of six CFAs and we have 21 managers. Our CFAs know the fund managers inside and out. Our evaluation process is a five-step process. The first thing we seek is an institutional money manager that is successful in the institutional space and that meets our standards for organizational stability. We don't want to have managers that are worried about their paycheck. Nor do we hire managers that are start-ups. We prefer firms that are financially sound and have some share of employee ownership. Second we evaluate the personnel. We prefer a team with low turnover and that their incentive structure is aligned with our interests of outperformance in the long run, not for the short run. We also consider team size and whether it is appropriate for the size of the universe from which they pick stocks and the number of names held in the portfolio. The third step of our evaluation looks at the investment discipline. Do they have a disciplined, repeatable process that is logical and embraced by the team? Given our bias toward high Active Share and more concentrated managers, we look for managers with strong fundamental underpinnings. Not only are we evaluating the depth of analysis, but also the consistency of approach across the team members. We believe that consistency, or lack thereof, will flow through to relative performance results over time. Fourth is infrastructure. We need to make sure that the team has the tools they need to effectively execute the strategy on a day-to-day basis. We evaluate back office systems, compliance, and trading. Failings in such areas can stop a firm in its tracks such that the focus no longer becomes about delivering excellence in investing but, rather, fixing the problem. Finally, we cap off the process by examining performance results. We only feel that by understanding the rest of the firm, its people and its processes do we have the insight to understand and evaluate the performance produced. And we believe all four qualitative areas are necessary ingredients to produce compelling results going forward. Those first four elements can be thought of as the foundation upon which the results are built. Naturally, when it comes to analyzing returns, we’re looking beyond the results through the most recent quarter or year. Given the philosophy and process utilized to construct and maintain the portfolio we can develop expectations for how the strategy should perform in different market environments relative to the benchmark and peers. Much of our results analysis surrounds an historical evaluation of how the strategy has performance versus our expectations. The analysis covers absolute and relative returns, the risk profile, and risk adjusted returns. Q:  When do you decide to terminate the relationship with a manager? A : Many people find it interesting that – at least during my four-year tenure here - we haven’t terminated a manager for strictly performance reasons. We have made several manager changes. Some occurred when we acquired other mutual fund complexes and the existing managers didn’t meet our criteria. Others were related to changes in personnel and/or deficiencies in implementation of the strategy. Certainly, some of those were accompanied by performance issues, as well. Ultimately there is one major question that we need to answer in our ongoing due diligence: has anything changed that might compromise the manager’s ability to continue to manage the strategy in the same fashion as originally communicated? It could be a change in control, team turnover, or a change in the incentive structure. We need to be confident that the manager is capable of delivering the same product that we contracted them for at the outset. When that confidence is shattered we need to replace the manager. Q:  What do sub advisors do to minimize the downside losses, because active managers can underperform too? A : You know, we’ve spent a good bit of time analyzing and talking about this issue. There really isn’t necessarily a correlation between Active Share and risk or “downside.” Some of our sub-advisors have more aggressive profiles that tend to do better in rising than falling markets. I mentioned Sands Capital earlier as such an example. But others like The London Company and Barrow Hanley of Dallas, Texas tend to excel most in difficult market environments when stock prices are falling. It really comes down to the strategy. The London Company focuses on buying companies that they believe are trading at a steep discount to their true value. Barrow Hanley buys stocks with lower valuations and higher dividend yields than the market. Buying stocks “cheap” has created a risk profile for the strategies they manage that has participated in far less of the downside than relevant benchmark indexes. The key to success, with such highly active managers, is understanding the types of shorter-term periods when they will lag and when they will shine. Certainly, investors are right to expect that the combination of lagging and shining periods ultimately leads to outperformance. We believe managers like Sands Capital, Barrow Hanley and The London Company have exhibited over long periods of time that patient investors can be rewarded handsomely.