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Why have passive investments grown globally?
In hindsight, the fact that passive investment strategies have grown over the last decade is unsurprising. Following the 2008 global financial crisis (GFC), attention was focused on certain active investment strategies which had not delivered, alongside the importance of fee structure to client returns, in what appeared then to be a lower-return world. What is surprising, however, is the extent of the inflows that passive strategies have received. Bernstein1 estimates that over the last decade, inflows into passive funds and exchange-traded funds (ETFs), in the US alone, have been US$1,300 billion. The company estimates that, if this rate of flows continues, over half of equity assets under management (AUM) in the US will be managed passively by early 2018. Even more remarkably, this number will still be less than in some other geographic markets – in Japan, the passive share is already 72%.
In light of this trend, we analysed the performance of the active industry over the period and discovered that perhaps it is not as bleak as some in the industry seem to believe. Then we examined the relative attractiveness of active for investors. Finally, we drew some conclusions on the potential long-term effects of the growth of passive on investment markets, the wider economy, and society in general.
Is the growth of passive investments down to human behavioural biases?
Pick up any asset management industry publication today and you will no doubt encounter numerous calls for, or predictions of, the death of active investing. These articles point out the dramatic growth of passive investing, alongside the fall in active fund performance following the GFC (Figure 1, overleaf).
But this picture misses the fact that financial markets, like most things, go through cycles and often reverse at just the point when the trend looked the strongest.
Looking back over the past three decades, there have been several times when particular investing approaches have been mistakenly called into question. For example, in the run-up to the tech bubble in 2000, Value investing was declared dead, as Growth managers came to the fore2.
Source: Fund Management Strategy: Nearing 50% passive milestone. Sanford C. Bernstein & Co. April 2017
This was just before Value staged a remarkable recovery and outperformed consistently until the GFC (Figure 2, overleaf). Perhaps, unsurprisingly, there are calls for its death today, as well3. Quality investing offers another example of this dynamic. The style clearly demonstrates its redeeming properties during bear markets, but performance, although not as volatile, is just as beholden to cycles as a Value or Momentum approach.
As with most things linked to human behaviour, cognitive biases may be the root cause of these flare-ups. ‘Recency bias’ comes to mind, where we tend to extrapolate the future from recent events, ignoring longer-term data sets. Another is our tendency to follow the herd. In both cases, the outcome is the same: a fundamentally sound yet out-of-favour investment approach begins to encounter more favourable conditions and the fund flow reverses. We should consider, therefore, whether the ‘rise of passive’ is just another cycle that is set to reverse when market conditions change.
Figure 1: The rise of passive investing
Source: Bloomberg & Morningstar. Based on the Morningstar Global Equity manager universe. Average pre and post financial crisis outperformance is based on 1 year rolling excess returns – calculations based on percentage number of managers achieving positive returns within the universe. Pre-crisis = January 2001 to December 2009, post-crisis = January 2010 – December 2017
What does the evidence suggest about active performance?
There have certainly been studies despairing of the performance of active managers, such as Blake (2014), which used UK data from 1998-2008 showing that only 1% have beaten their benchmark net of fees4. Yet there are also contrary examples. Gerakos (2016)5 for example, concludes, using US data from 2000-2012, that active managers can add value6. His evidence puts their net-of-fees outperformance at 0.37% for US markets and 1.07% for global ex-US markets.
Similarly, eVestment’s database of global equity managers’ performance shows that the median of the peer group has outperformed the benchmark over the past 3, 5, and 10 years7 (Figure 3, overleaf).
Figure 2: Active manager performance goes through cycles (%)
Source: Investec Asset Management, Bloomberg, as at 28.07.17. Value, Quality and Momentum investing: 3-year rolling annualised return in excess of MSCI ACWI (%)
Figure 3: The median of the peer group has outperformed the benchmark
Source: eVestment, as at Q2 2017. Benchmark is the MSCI ACWI Index
As these results are both somewhat contradictory and perhaps surprising, it is worth examining the possible reasons behind them.
First, we must acknowledge the importance of fees to these outcomes. Blake’s study is on retail funds, while the other two focus on institutional funds. While noting this difference, it is clear that the trend for reduced fees improves the likely outcome for all clients. Second, the longer-dated eVestment figures do acknowledge a certain ‘survivorship’ bias in the collection of active managers included on the database. But, on the other hand, this reinforces the belief that investors with a long-term focus are rewarded for selecting tried and tested active managers.
Either way the performance of the active management industry has been better than many perceive. This has been against a particularly unfavourable backdrop which may now be about to improve.
When will the cycle turn?
The biggest determinant of the opportunity set for active fund managers is the overall level of correlations (Reibnitz 2015)8. Following the GFC, the opportunity set for active managers has narrowed dramatically, as stock correlations have been, on average, much higher than before (Figure 4). The ‘pay-off’ for active management, as measured by return dispersion (Figure 5)9, has also been very low by historical standards, implying a low pay-off for taking active risk.
Note that correlations have dropped recently, while dispersion remains stubbornly low. Even so, we find it particularly interesting that the opportunity set for the active industry may be improving, while at the same time the historical performance of the industry has been under-appreciated.
What is an ‘active manager’?
Studies berating the ‘average active manager’ overlook or obscure the fact that the industry is extremely heterogeneous. So, what exactly are we referring to when we refer to an ‘active manager’?
In 2009, Cremers and Petajisto10 provided a useful segmentation (Figure 6, overleaf):
- Active stock-pickers take large, but diversified, positions away from benchmarks.
- Those that focus on factor bets can exhibit large benchmark-relative volatility, despite small active positions.
- Concentrated funds combine very active stock selection with exposure to systematic risk.
- A large number in the middle are moderately active but lack a clear, distinctive style.
- Closet indexers, meanwhile, do not engage in much active management at all.
Figure 4: Pairwise correlations are falling
Source: Investec Asset Management, as at 31.07.17. Correlation = the degree of co-movement between assets. Based on the 4FactorTM global equity universe
Figure 5: Return dispersions are historically low (%)
Source: Investec Asset Management, as at 31.07.17. Dispersion = the gap between the best and worst performing stocks. Based on the 4FactorTM global equity universe.
Figure 6: What exactly is an ‘active’ manager?
Source: Cremers, M (2009), ‘How active is your fund manager? A new measure that predicts performance’. Investec Asset Management HARP.
It was shown at the time, and confirmed more recently (Cremers 2017)11, that the most active stock-pickers consistently outperform12. The trouble is, there are only a few of them and this number is estimated to be less than one third.
Ten years on, Cremers goes on to spell out the ‘three pillars of active management’:
- Skill: a function of whether one’s investment philosophy is sensible. Is the investment process used to extract this philosophy disciplined and repeatable? How good are the people and the supporting infrastructure?
- Conviction: as measured by Active Share. More so than any other statistic, it captures the effort that goes toward researching and selecting investments, regardless of the benchmark constituents.
- Opportunity: that is, the number of stock-picking opportunities that exist. This is the pillar which is affected by market conditions and, as we have already seen (see Figures 4 and 5), return dispersions are historically low and pairwise correlations are high. It is an area which is potentially becoming more supportive to active managers.
Putting this all together we find that not only are there active managers that have successfully beaten their performance comparison index over long periods of time, but that they tend to share certain characteristics.
Overall, we have tried to show that in order to have an informed debate about ‘active versus passive’, we must understand two points. Firstly, the success of various approaches to investing goes through cycles, and ‘active’ may be at an interesting juncture. Secondly, not all active managers are equal, in that some are more active than others.
Does active have any wider benefits?
“If you think the economy is more important than the environment, try counting your money while you hold your breath.”
Professor Guy McPherson, School of Natural Resources, University of Arizona.
The active and passive segments of our industry need each other to survive and thrive. Passive strategies leverage off active managers who make markets more efficient than they would otherwise be, while active managers aim to exploit some of the inefficiencies that their passive counterparts bring to the marketplace. It’s a somewhat ironic and yet symbiotic relationship. But besides the ‘potential’ to achieve performance better than a passive benchmark (even net of fees), we believe there are wider benefits to active management and even some unintended consequences of passive investing.
Better allocation of capital
In order for capital markets to function efficiently they must be liquid, transparent and act as a mechanism for efficient capital allocation. At a company level, active managers play an important role in ensuring that markets have these characteristics. They make strategic decisions to support new companies, entrepreneurship and innovation which, in turn, supports long-term economic development.
Shareholder oversight of company management
Passive funds take no view on the quality of a company’s management or long-term business strategy. Therefore they have little ability to provide shareholder oversight of company management, such as the company’s environmental practices or labour policies. Since the GFC, there has been a greater focus on companies’ non-financial impact – broadly grouped as environmental, social and governance (ESG) impacts. This covers a wide range of complex issues, many of which are becoming increasingly important to investors. These include: climate change impact and opportunities; carbon emissions; supply-chain oversight; labour relations and pay.
Unintended market and social consequences
In financial markets, high levels of passive investing may also have unintended consequences – there has been rapid growth in exchange traded funds (ETFs) and mechanistic trading algorithms, which impact the way the market mechanism works. Regulators are currently reviewing the consequences, including flash crashes, the high level of trading at the close and ETF liquidity squeezes.
As responsible allocators of capital and responsible company shareholders, it is part of an active manager’s responsibility to ensure appropriate systems of governance, and management of environmental and social factors for these companies. As an industry, this approach to active management may have material positive implications for the market and, in the longer term, for society. In a world where investors are increasingly looking to supplement their capital growth expectations with a positive social impact, fairness, equality, and an environmentally sustainable future, passive investing may not enable the appropriate change.
These issues need to be considered in the context of company valuation and for an aggregate portfolio. Individual client requirements are also playing a greater role with exclusion-based mandates no longer sufficient to link ESG to client preferences13. Clients are revising their mandates, requiring their asset managers to unlock value through improved engagements and targeted initiatives.
Conclusion: Proven, long-term active managers are here to stay
There has been a dramatic rise in passive investing, which seems to have coincided with a less favourable performance period for active managers. However, the success of various investing approaches goes through cycles. The rise of passive investing, away from active management, should perhaps be seen as just another cycle. The opportunity set for active stock selection has recently improved, suggesting that the cycle may be turning in favour of active management once again.
There are many studies out there despairing of the performance of active managers. Yet some evidence seems to suggest that the performance of the active industry has been better than many perceive. And it’s always worth remembering that not all active managers are equal, in that some are more active than others.
Beyond investment performance, there are wider benefits to active management and there could be unintended consequences of passive investing that cannot be ignored. In our view, active managers will continue to have a critical stewardship role to play in the decades that lie ahead.
- Fund Management Strategy: Nearing the 50% passive milestone. Sanford C. Bernstein & Co. April 2017.
- Death of Value: Snider. B, Kostin. D; ‘The Death of Value,’ June 2017, Goldman Sachs Portfolio Strategy Research: US Thematic Views.
- ‘New Evidence on Mutual Fund Performance: A Comparison of Alternative Bootstrap Methods’ David Blake, Tristan Caulfield, Christos Ioannidis & Ian Tonks. June 2014.
- ‘Asset Managers: Institutional Performance and Smart Betas’ Joseph J. Gerakos, Juhani T.Linnainmaa, Adair Morse. November 2016.
- This outperformance is completely explained by their exposure to factors.
- eVestment, as at 30.06.17. Based on the MSCI ACWI Index.
- ‘When Opportunity Knocks: Cross-Sectional Return Dispersion and Active Fund Performance’ Anna von Reibnitz. September 2015.
- Correlations (degree of co-movement between stocks) and dispersion (the performance gap between the best and worst performing stocks).
- ‘How Active is Your Fund Manager? A New Measure That Predicts Performance’, May 2009. Cremers and Petajisto.
- ‘Active Share and the Three Pillars of Active Management: Skill, Conviction, and Opportunity’. Cremers, 2017.
- Closet indexers on the other hand, are increasingly catching the ire of investors. FT: Regulators must tackle closet-tracking ‘epidemic’. www.ft.com/content/82f86aba-f45a-11e6-95eef14e55513608.
- Investec Asset Management’s stewardship statement can be found at http://www.investecassetmanagement.com/expertise/stewardship/reports-library/. Our recently launched sustainability initiative highlights how we will act as a firm.