Active and passive investment need to learn to get along.
To put it mildly, it has been a good year for passive investment funds that track a broad market index. Much of it has been at the expense of their active peers, which try to seek out undervalued investments. Almost $500 billion has moved from the latter to the former so far this year. This keeps up a trend that has seen massive flows from active to passive strategies in recent years and the gradual growth of passive over the last 30 years.
The predictions of the imminent demise of active management that have followed are wrong. After all, PricewaterhouseCoopers predicts actively managed assets will increase to $74 trillion by the end of 2020, marking a 26.7% increase. But active and passive managers need to learn to live alongside one another.
The uncomfortable truth for some active managers is that passive managers have been able to take market share for a reason. There are still too many managers who claim to have an active approach but actually hug a benchmark. Investors can assess whether managers really are being active by looking at their active share. But it doesn’t tell the whole story.
Similarly, active managers cannot guarantee that they will outperform the index. That can be an uncomfortable reality for some, especially when fees are accounted for. The generally higher fees of an active approach can have a significant impact on returns.
Passive is not a panacea
But none of this means that passive is a panacea. The immense scale of available information, speed and volume of trading and depth of analysis has made some markets much more efficient than they once were. Active managers, unable to find the inefficiencies that they once did, have lost out in some of them. Yet there are highly inefficient markets like emerging markets where an active approach can be a real benefit.
Active managers, at their best, have a diligence that no algorithm can match. Diligence is important because clients increasingly demand that managers pay attention to other factors beyond pure returns. Issues like good governance, environmental standards and employee diversity matter more and more.
We are stewards of other people’s money, and algorithms don’t have a conscience.
We are stewards of other people’s money, and algorithms don’t have a conscience. They can’t ask the difficult questions or interpret the nuance between what management says and does. Diplomacy and tact are required, as is the willingness to vote against the herd.
There is growing concern that the volume of money invested in passive investments will at some point stop financial markets from performing their function of efficiently allocating capital in the economy. It’s enough of a worry for the world’s biggest pension fund, Japan’s $1.4 trillion Government Pension Investment Fund, to start investing more in active managers.
No one knows when we might reach that inflection point. But financial markets are already distorted from nearly a decade of quantitative easing that has lifted markets with scant regard to fundamentals. When the tide of quantitative easing goes out in the coming years, it should be easier to assess fundamentals and give genuinely active managers an opportunity to shine. Several studies have shown that active funds have an edge over different points in the cycle, as well as over the long term.
The point here is that both active and passive strategies have their strengths and weaknesses. Asset managers do themselves no favors in pretending that either approach doesn’t have a place in clients’ portfolios.
No place for closet trackers
For their part, active managers need to change: there’s no place for closet trackers, a lack of transparency and high fees for poor performance. If they say they’re active, they need to be active. At a wider level, we need to recognize that other factors can be as important as returns –whether that is a low-cost solution or a rigorous, labor-intensive approach to stewardship.
It’s about managing strategies actively so clients navigate geopolitical uncertainty, market volatility and cycles smartly and not simply weather them.
Clients themselves are increasingly demanding more tailored solutions rather than off-the-shelf products. This will lead to greater blending of strategies and, in general, an appreciation that no one product is a solution in itself. We live in a world where active and passive have to live alongside each other. The sooner we all recognize that, the better.
A version of this article was published in Investment Week on September 5, 2017.