November 2016

ACTIVE VS PASSIVE: Suspicious minds

Over the past two decades passive investment vehicles – first index funds, now ETFs – have eroded active managers’ proposition. Moreover, a band of activists have made it their mission to chastise active managers’ records. While the group is growing all the time, there are several prominent critics - usual suspects - that frequently crop up in the media to give active managers a kicking. Kit Klarenberg speaks to them.

It seems like every month, new data offers a damning indictment of active managers. October’s instalment arrived courtesy of S&P’s active-vs-passive scorecard, known as Spiva; it showed almost all actively managed US, global and emerging market funds have failed to outperform their benchmarks since June 30, 2006.

The numbers are genuinely staggering. According to Spiva, 99% of active US equity funds, 98% of global equity funds, 97% of emerging market equity funds and 90% of European equity funds failed to beat their benchmarks.

The figures may  have made uncomfortably welcome reading for the cluster of academics, investors, consumer advocates and journalists who have made it their mission to shake up or even end active managers’ stranglehold on the investment marketplace. This small group has multiplied in number in recent years – and their dissent has gained in volume, too. Here, four prominent malcontents explain why they have it in for active managers.

A SIMPLE TRUTH
David Blake is professor of pension economics at Cass Business School, and director of the Pensions Institute.

Two years ago, Blake’s department conducted research on the performance of active funds. The findings offered much the same conclusion as Spiva’s data – one in a hundred managers managed to outperform the market over a meaningful period. Moreover, even end investors in these funds see no benefit from this outperformance, due to operating and trading costs.

“It’s a simple truth that most active fund managers can’t beat the market, and the minority that do add value end up pocketing it themselves. Our research found investors in UK equity funds would be almost 2% better off annually on average by switching to a FTSE tracker,” he says.

“Typically, when you find a fund that has outperformed consistently, it’s over a very short timeframe indeed – three years at the absolute most – and that could be down to pure luck or market momentum. The performance figures of asset management firms overall are also heavily biased in their own favour, as they don’t include data on funds that have closed, or merged with other funds, due to poor performance.”

Still, Dr Blake says active managers can play a positive role – namely, identifying and investing in companies that use their capital most efficiently, thus optimising aggregate growth. Furthermore, he says the industry could be vastly improved if it were restructured to put investors first, with any outperformance flowing directly to investors. However, the professor isn’t holding his breath.

“Active managers will never accept that they underperform the market. At most, they’ll rebrand themselves and their strategies under a new banner, like smart beta, and carry on as they’ve been carrying on,” he says.

MISLED FOR TOO LONG
Robin Powell is the director of The Evidence-Based Investor.

“My goal is to inform investors about what the evidence on investing says. Investors have been misled by the industry’s PR machine for too long – they deserve the honest truth,” he says.

To achieve this end, Powell publicises independent, peer-reviewed research dating back to the 1950s on how best to invest.

He says the findings are consistent – picking stocks and timing the market, or choosing an “expert” to do it for you, is a waste of time and money, and transaction costs destroy returns; instead, investors should assemble a diverse portfolio of “cheap, boring index funds”, and forget about it.

“I don’t have anything against active management in principle – but there are far too many, trading far too much, charging far too much, and delivering far too little value for end investors. If there were far fewer, which charged much less and were much more transparent, there may be a case for including one or two in a diversified portfolio,” he says.

“Of course active managers can beat the market over the long term – by the law of averages some will – but those funds are almost impossible to identify in advance.”

Powell’s one-man agitation of the funds industry has significantly gained in momentum over the past year. On top of producing and presenting Sensible Investing TV’s acclaimed documentary How to Win the Loser’s Game, he helped organise the world’s first Evidence-Based Investing conference, held in New York in November of this year.

While Powell finds the shift towards passive vehicles over the past year extremely encouraging, he dismisses the notion that passive management will supersede active management entirely, much less that it will dominate the market any time soon.

“In the US, passive funds still account for only a modest proportion of total investable assets, and almost everywhere else in the world, indexing has barely scratched the surface. It’s taken over 40 years for passive to reach this point in the States alone – passive investing isn’t going to achieve worldwide domination overnight,” he says.

“There will always be active investors. It’s human nature to think the market can be beaten, and there will never be a shortage of fund managers willing to take money off people who want to give it a try. Even if we reached a situation where almost everybody indexed, it wouldn’t stay that way for long. If passive investments became inefficient, that inefficiency would create an incentive to become an active investor – in those circumstances, I would certainly be one of them.”

HEADS IN THE SAND
Gina Miller is the creator of True & Fair, which campaigns for cost transparency in financial services and products, and co-founder of investment manager SCM Direct. Her issues with active management are manifold, but unsurprisingly, opacity around fees looms large in her litany of objections.

“The vast majority of active managers are acting akin to a cartel and refusing to grant their clients the basic consumer rights of knowing what they are truly paying and buying,” she says.

Moreover, Miller feels the industry’s current operating model is increasingly redundant and outdated. While the post-financial crisis milieu for some time proved highly amenable to active strategists, she says regulatory developments since 2008 have also sown the seeds of active management’s destruction – or at least, the end of the industry as we know it.

In short, legislation designed to “rein in investment managers”, such as Dodd-Frank and the Corporate Governance Code, has had the “inevitable” effect of eroding active managers’ “edges”, and created a fertile environment for passive investment vehicles to proliferate.

Nevertheless, Miller doesn’t view active and passive in adversarial, binary terms, and doesn’t foresee or even wish for the end of active management. She even sees nothing wrong with closet index funds – as long as they aren’t marketed as fully active vehicles, and don’t charge active fees for their services.

Her ideal marketplace is one in which active and passive strategies are merged, with managers taking a ‘core-satellite’ approach; passive holdings comprising the majority of a portfolio, and managers taking additional positions to outperform the market.

Until that paradigm comes to pass, Miller will continue to propound passive’s benefits, while hammering away at active managers that offer average or poor performance for a premium – although, she warns that the industry as it stands today is on the verge of collapsing under the weight of its own contradictions in any event.

“Pressure around transparency, the banning of commissions and research payments, and increasing layers of inefficiency and intermediation, coupled with the rise of new innovative financial technologies, such as online wealth managers and robo-advice, mean the threats to traditional active managers appear to be steadily increasing,” she says.

“How long can active managers bury their heads in the sand?”

THE REVOLUTION HAS BEGUN
A fervent promoter of passive for decades, Larry Swedroe has authored 15 books on passive investing. His case against active management is simple; the vast majority of passive vehicles consistently offer returns in line with the performance of a market at low cost, while the vast majority of active funds consistently underperform the market, at great expense. “Of course it’s possible to beat the market via active management, but the number of funds that do is a small and ever-shrinking community,” he says.

“Presently, data suggests investors have a one in 50 chance of outperforming the market if they invest in an active fund.

“I don’t like those odds – especially as investors may not even benefit from that outperformance after fees, taxes and charges are factored in.”

He has propounded his belief in the primacy of passive investment vehicles since his first work, 1998’s The Only Guide to a Winning Investment Strategy You’ll Ever Need.

In it, he foresaw a major sea change in years to come – one that would sweep away the vast majority of active managers and see passive investment vehicles become the default option for investors.

Quite when this tidal wave would strike, Swedroe didn’t then speculate – although, the evidence suggests it has been rapidly gathering pace over the past 18 years. In fact, he believes in years to come, 2015 will be regarded as the year this revolution began in earnest and the point of no return for the active management sphere in its present form was passed.

A cursory glance at inflows into passive and active investment strategies over the past five years suggests this analysis may be correct. Active managers still rule the roost when it comes to assets under management, but this is rapidly changing. In January 2011, according to Bank of America Merrill Lynch data, passive vehicles held under a fifth of fund assets. At the close of 2015, this had grown to a third. Is this deluge a one-way street? Swedroe is convinced it is.

“The vast majority of the active world will disappear in the next 20 to 30 years. At least 80% of active funds have no reason to exist. They’re dead men walking, whether they know it or not.”

FOR WHOM THE BELL TOLLS
Active managers may draw some comfort from the fact that these critics, while voluble, aren’t willing the complete destruction of the active management sphere – they neither think this is a desirable eventuality, nor even a possible one. They may not come in peace, but they do not come to bury asset management either.

Still, it’s evident that the knives are out for active managers and aren’t going to be retracted. The European Commission intends to launch an inquiry into the asset management industry, to examine performance, fees and profitability. In the UK, the Financial Conduct Authority has already launched an investigation on much the same lines – the results are due later this year.

Morningstar figures suggest that since 2007, passive assets have grown four times faster than those held by active funds. While some of this fresh capital flows from new investors, the bulk is being moved directly from active into passive. Active investment may not go the way of the dodo, but the prospect of it becoming a minority in its own industry is increasingly appearing a very real one. The time for active managers to sharpen up their collective act and outperform has very much come. Watch this space.

©2016 funds europe