On one side of the investment management debate stage: Proponents of actively managed portfolios. On the other side: Advocates of passive indexes and ETFs. Who’s winning? Who’s whining? Indeed, for the last few years, passive investing has bested active management.
But wait. Passive is actually creating opportunities for active, and the outlook for actively managed strategies is upbeat. So says William Priest, CEO and co-CIO of Epoch Investment Partners, in an interview with ThinkAdvisor.
Before co-founding Epoch in 2004, Priest spent 30 years at Credit Suisse Asset Management Americas as chair-CEO and CEO of its predecessor firm, BEA Associates, which he co-founded in 1972.
Priest makes the case for active investing in his new book, “Winning at Active Management: The Essential Roles of Culture, Philosophy and Technology,” co-authored by Epoch portfolio managers Steven D. Bleiberg and Michael A. Welhoelter, with John Keefe. Barron’s calls the book “a manifesto for stock pickers.”
New York City-based Epoch has nearly $43 billion in assets under management; assets under advisement total about $49 billion. One of its principal strategies, Global Equity Shareholder Yield — a dividend-like product, as Priest describes it — has had an annualized risk-adjusted rate of return of 7.9% since its 12/31/95 inception.
Back in 2007, the astute portfolio manager recognized that dangerous doings in the subprime loan market signaled wide-ranging disaster ahead. That April, in a white paper, he wrote: “Mortgage-backed CDOs and RMBS [Residential Mortgage-backed Securities] are analogous to termites in their ability to silently wreak fatal, widespread and immediate havoc.… The ‘subprime canary’ has dropped, and that’s very bad news for the rest of the coal mine.”
In our interview, Priest, 75, discusses major reasons for active managers’ underperformance, along with his firm’s effective approach to selecting stocks.
Here are excerpts from our conversation:
THINKADVISOR: Are good times in store for active management?
WILLIAM PRIEST: Absolutely. When I see articles in favor of passive management, I rub my hands together: This is fantastic! You’ll still see a shift of assets from active to passive; that swing will go on till there’s some kind of accident in the passive world. But going forward, the opportunities for active managers will get better, not worse.
If you get into a world that’s passive, the opportunity for active is terrific because in a passive portfolio, such as an index fund, you own everything – the good stuff and the bad stuff. You often own things that go broke in the course of a year. Opportunities for active management are created just by the lack of price discovery by indexation.
How do you win with active management?
Not all managers will deliver returns over the long run. But some will. To win, you need three things: a certain kind of organizational culture; an investment philosophy that’s tied to something very fundamental in that the financial theory behind it is demonstrable in its integrity; and — going forward in particular — the ability to show that the technology embedded in your business and investment process has scale capability and can generate insight.
So which strategy do you think will win out — active or passive?
The world is never going to be all one or all the other. We may wind up with a mix of maybe 60% passive and 40% active. I really have no idea. But there will always be active management.
Why has it been so difficult for active managers lately?
The last five years of active managers’ underperformance is explainable in terms of quantitative easing and the absolutely overwhelming performance from P/E multiple expansion – which I think is over.
QE essentially brought interest rates down to an [extremely] low level, and there has been an expansion in the value of financial assets. You could be a very good analyst, but you were overwhelmed by multiple expansion. Unless you realized that multiples were going to expand because of central bank policy – principally QE – you missed the market.
How has your firm’s strategies performed in the recent past?
I would be misleading you if I said the last five years haven’t had their challenges. We’ve had some products that have done exactly how you hoped they would: they had positive returns. But some haven’t. From inception, though, when [these] products were] launched, 10 or 15 years ago, the numbers are generally better than the market and there’s been slightly less volatility.
Why do you think P/E multiple expansion is over?
If it expands, it will be an incredibly small amount and will happen only because interest rates go even lower. The chances of that are very slim. The most important driver of P/E ratios is interest rates. When they’re low, P/E ratios are high; and vice-versa.
Why do active managers frequently underperform?
They often fail because they don’t do what they say they do. They’ll lay out an approach; but very often, if you look closely, you’ll find that over time, they really didn’t do that on a consistent basis. One year they were value; two years later when value wasn’t working, they became growth. And when growth wasn’t working, they went back to value. Their process was inconsistent: they zigged and zagged.
Any other reason?