The concept of “survival of the fittest” is inherent to capitalism, as much as it is to evolution in the natural world: Either a company or product makes money, or (eventually) it dies out.
The principles of “adapt to survive” are also evident in asset management today—and the active management industry is being forced to evolve ever faster. New regulations at both national and international levels are causing headaches for managers and their clients; political uncertainty is creating nervousness in financial markets; and a new focus on value for money is putting more downward pressure on fees than ever before.
Then there is the push from defined benefit to defined contribution, reducing the pools of sticky institutional money and leading managers to focus increasingly on the short-term, easily spooked world of individual investors.
As the active industry fights to meet these challenges, a predator looms, growing in size and strength: passive management.
But is this a development active managers should fear? Perhaps not, for there are those who feel passive investment could, inadvertently and counterintuitively, become the saviour of active managers.
Art by JooHee Yoon
More than 10% of the S&P 500’s entire $17.5 trillion (€14 trillion) market capitalisation resides in exchange-traded funds or other passive strategies directly tracking the index, according to S&P Dow Jones Indices. Accounting for products tracking broader indices including S&P 500 constituents, this proportion is likely much higher.
September saw the eighth consecutive month of inflows into US passive equity funds and the seventh consecutive month of outflows from US active funds, according to Morningstar. In the 12 months to the end of September, passive strategies added $131 billion while active funds saw withdrawals of $63 billion, implying that both new and existing investors prefer index tracking.
In the UK, the Investment Management Association noted a 343% increase in the assets held in “tracker funds”—passive mutual funds—across all sectors and asset classes between December 2004 and December 2013. Tracker funds now account for more than 10% of the UK investment management industry, with £85.2 billion (€109 billion) under management.
On the anecdotal side, Stefan Beiner—head of asset management of the PUBLICA pension fund in Switzerland— believes that because of the rise of passive, the metrics index providers use to select companies will become more and more important.
So how could this possibly be a blessing for active managers?
Simon Evan-Cook is a portfolio manager at UK-based Premier Asset Management on its fund-of-funds team, which has seen significant success in the UK retail space—primarily, it must be highlighted, through active management. In a recent research paper, he tables a hypothetical case to demonstrate that the very best alpha hunters could exploit a market dominated by passive asset owners.
“Suppose everyone went 100% passive today: Every investor now holds the same proportion of their portfolio in exactly the same stocks,” Evan-Cook says. “No one does better, no one does worse, and prices do not move to reflect the fortunes of the underlying businesses.”
“Fairly soon, some bright spark will figure out that if he buys extra shares in a company, he will raise its weight in the index, so everyone else will have to buy that stock to match its new position in the index. This will cause its price to spiral upwards. He can then sell those shares at a large profit—causing their price to fall again as everyone copies him—then repeat the same trick with other stocks, turning it all into a highly profitable game of follow the leader.”
While admitting this scenario will never happen, Evan-Cook claims the hypothesis illustrates an “undeniable truth”: Passive investing will one day become so popular that active investors can easily take advantage.
Even if no market ever gets to the point at which one sole investor is calling the shots, consultants and other commentators tell CIO the idea definitely holds water.
The revolution hasn’t started yet, says Morningstar’s Vice President for Research John Rekenthaler, but it will. “Eventually the growth of passive will help active,” he says. “At some point, we will reach a level at which the percentage of passive is so high that becomes easier for active managers to find mispriced opportunities.”
Josh Brown, a financial commentator and CEO of New York-based advisers Ritholtz Wealth Management, claims passive investing may be approaching a peak in popularity—and this could also offer active managers an opportunity. “For a number of years, people have been abandoning active management,” he says. “Nobody believes it can work anymore. As a result, there will be fewer people trying to create alpha. Active has done terribly this year, but longer term that’s what the peak in passive could mean—if nobody is turning over the rocks looking for good companies, there is an opportunity for alpha.”
Rekenthaler calls this “the paradox of passive”: the more people that back these funds, the less attractive passive investing becomes.
Brown also points out the cyclicality of investment styles, and argues that passive could drift out of fashion in the same way that the popularity of value or growth styles rises and falls. “There is always an opportunity for active managers, but in some years people don’t care,” he adds. “Last year, if you held the Russell 3000 you made 34%; if an active manager made 36%, who cares?”
Barry Kenneth, CIO of the UK’s Pension Protection Fund (PPF), calls the hypothesis “interesting” but argues that “when the cost of borrowing is low, it only takes a small number of informed active investors to keep markets efficient… In the future,” he adds, “stock pickers may be able to earn better returns owing to the increased cost of capital for banks and the presence of ‘fair weather’ liquidity providers like high frequency traders.”
The Worst Fund in the world resides in Liechtenstein.
Run by a small Swiss wealth manager, it doesn’t have too many backers; there was just $2 million in its portfolio in September. If you do decide you want in, it’ll cost you 3% upfront, and 3% every year after that.
There is a 10% performance fee as well, but fortunately for the existing investor(s), it hasn’t been levied in a while: In the five years to October 30, a period in which the S&P 500 delivered 112% returns, the fund lost a staggering 43%.
A brief scan of its top holdings reveals one reason behind its performance: The portfolio is full of small commodities specialists, such as miners, oil and gas explorers, and precious metal manufacturers. But this doesn’t explain why the fund still exists, after ranking at the bottom of performance charts over any period you care to mention.
Fortunately, the days of third-rate active managers like this Swiss minnow may be numbered.
Evan-Cook claims that as investors’ patience wears ever thinner, asset managers are forced to shut down underperforming funds sooner—leaving the (presumably) better active managers with a greater market share. The end result, logically, would be a market consisting primarily of talented active managers and index-tracking products.
“We believe this is Darwinism,” Evan-Cook says. He cites the UK’s collection of Japanese equity funds as an example of a “dusty corner of the industry” that had been neglected by investors for years until the Japanese government’s massive stimulus programmes were introduced last year. This led to weaker funds being shut down or merged away.
The PPF’s Kenneth points to “closet indexers”—funds that purport to be active, and charge active fees, but rarely deviate much from their benchmarks—and predicts they will be eventually “squeezed out because their fees will look high compared to exchange-traded funds.”
Morningstar’s Rekenthaler says this change is inevitable. “I don’t think there is any question that is where the market is going,” he says. “There is a huge middle ground—more likely lower ground—of funds that are just sitting there and aren’t getting money any more. They are still profitable, but will be hard to grow and so will eventually by merged away.”
As the active market slowly evolves, and the weaker performers and those who fail to differentiate themselves gradually die off, will the fund selector’s job become easier? A CIO could surely either choose the low-cost passive path, or pay a little more for the best that the active market has to offer, without having to wade through terrible products to get there.
Not so, says Kenneth. “Picking outperforming funds will always be a challenging job because it requires a combination of skills: the ability to understand the market environment, the ability to evaluate individuals, the ability to assess business models, and a reasonable level of knowledge about the instruments being traded,” he says. “As a large fund, the PPF is able to deploy full-time resources to this function, but for smaller funds this may not be viable.”
PUBLICA’s Beiner voices caution on the idea of a radical reshaping of the active management landscape, but the direction, he says, is clearer.
“I don’t think it is going to be easier to outperform, but we could see scenarios in which the good active managers get bigger and better,” Beiner states. “If you’ve just been lucky at all in the past, you won’t benefit from this. It may be fair to say that the good managers will have a higher probability of success.”
Kenneth’s point about the importance of the market itself is echoed by consultants and academics. Within equities, many asset owners have spoken of a preference for an active approach to small caps or emerging markets, for example. In both sectors managers are generally more likely to gain an information advantage over competitors.
Earlier this year, Paul Gregory and Tim Mitchell of the NZ$26.8 billion (€17.1 billion) New Zealand Superannuation fund made just this point in a white paper on manager selection. The paper—“Investment Manager Skill”—states that specific markets can contribute to a manager’s skill either because of the effort it takes to gain an information advantage, or “to use a fishing allegory, we are more likely to find a successful fisher if we first find a productive pond.”
Long after the Worst Fund in the World is consigned to history—along with the thousands of other poor performers—fund selectors will face another challenge: the paradox of skill.
The theory has been observed and documented by a number of academics both inside financial services and out—most notably in baseball, a sport famed for its reliance on statistics.
Initially, a small number of managers may outperform a given market due to their superior skill in analysing companies and sectors—just as star hitters such as Babe Ruth or Lou Gehrig dominated in the prewar years of baseball in the US. But as the sector evolves, other managers up their game. Younger managers come in with better qualifications and new ideas, and the skill advantage of the initial outperformers is gradually eroded. (Scoring more than 50 home runs in a season was a remarkable feat in Ruth’s era, but 12 batters have achieved it since 2000, although performance-enhancing drugs likely contribute to this figure.)
The concept is perhaps best summarised by Charles Ellis, founder of Greenwich Associates and an advocate of passive investing. As long ago as 1975, he claimed that “gifted, determined, ambitious professionals have come into investment management in such large numbers… that it may no longer be feasible for any of them to profit from the errors of all the others sufficiently often and by sufficient magnitude to beat market averages.”
Nearly 40 years old, the statement still (apparently) rings true. Ritholtz’s Brown summarises the paradox, saying that “the better the competition gets, the more skilled it gets, and so the harder it is to display skill.”
The nirvana of quality alpha competing solely against beta may be some way off, but even if it gets here, don’t expect an easy ride.
But perhaps the success—or failure—of active management will be decided by another factor altogether. Brown believes passive management is approaching the peak of its popularity, and puts forward two variables that could bring about a change in attitude: flat markets and people.
To explain the second idea, Brown says fund groups have sought to play down the importance of “star” managers or “celebrity stock pickers” in recent years, in an effort to remove key-man risk. (Their success is questionable: Invesco Perpetual and Schroders in the UK have fallen victim to this risk in the past two years, as did a certain fixed-income giant in Newport Beach, California, this year.)
“Fund groups are emphasising a team approach, but the negative side is it becomes harder for people to believe in ‘management by committee,’” Brown says. “People are much more willing to follow individuals.”
Although his statement rings true more for retail investors, research shows institutions often prefer to know the people behind the strategies, too. A 2013 research paper by Douglas Foster and Geoff Warren—of the University of Technology, Sydney, and the Australian National University, respectively—illustrates this. In “Interviews with Institutional Investors: The How and Why of Active Investing,” the authors study asset owners’ manager selection methods and report that, among other factors, people are important.
“A consistent theme to emerge from our interviews was the inherently subjective nature of the decisions processes surrounding the use of active management,” Foster and Warren write. “In this respect, a primary and striking aspect was the extent to which all interviewees commented on the importance of the attributes of the people they selected as investment managers… Considerable resources appeared to be devoted to learning about the individuals they select and maintain as managers.”
One respondent is quoted by the researchers as spending “100% of our manager research time trying to figure out what is special about the individual that’s going to manage our money,” while another talks of the “buying experience of a person or a team, that they have an ability to outperform that particular segment of the market.”
Evolution happens slowly. Don’t expect the market to be free of closet trackers in the next 12 months, but if the pressures on active managers continue, standards will have to be raised and the deadwood will have to be cut out. You may thank Vanguard and iShares—and that fund in Liechtenstein—when they do.