Passive funds are increasingly the destination of choice for investors, taking market share from active managers at an accelerating pace. Active funds experienced significant net outflows in 2016, losing more than $340 billion of assets. Passive funds benefited, gaining more than $500 billion in net inflows. (See Asset Managers Struggle With Outflows, Fee Compression)
Active managers are fighting to stem the tide of outflows, mobilizing resources to make the case for continued relevance. Highlighting the seriousness of the threat, the Mutual Fund Education Alliance (MFEA) organized a November summit that included active management heavyweights such as T. Rowe Price, Franklin Resources, Affiliated Managers Group and Janus to discuss how to combat the movement from active management to passive management.
The debate between active and passive camps covers familiar territory, though some of the arguments from 2016 are worth highlighting. One prominent critique of passive management portrayed index funds as a form of socialism, while others were critical of ETFs. Some defenders of active management highlighted the potential for active managers to protect capital in down markets; others presented active share as a key factor to be used in selecting managers more likely to outperform the market. (See Are ETFs Breeding Systemic Risks?)
Passive investors compared to socialists: A Sanford Bernstein report, The Silent Road to Serfdom, portrayed passive management as a form of socialism. The Bernstein report characterized index investors as “free riders” benefiting from market prices set by an endangered species of active managers.
The scenario envisioned by Bernstein could become a real hindrance to the markets if active funds became “extinct” and were replaced entirely by passive funds. Without the price-setting involvement of active managers, it is conceivable that there would be pervasive and extreme deviations between market prices and the intrinsic value of securities. Despite the increasing prominence of passive funds, actively managed funds still represent nearly two-thirds of U.S. mutual fund and ETF assets, and are far from extinct as a species! The volatility of security prices and adjustment of prices after meaningful macroeconomic or company news provides evidence that a price-setting mechanism still functions.
The popularity of ETFs raises correlations and distorts capital flows: ETFs are a popular target of critics of passive management. One recent criticism suggested that ETFs caused rising correlations and indiscriminate capital flows to ETF constituents, contributing to an environment that makes it difficult for active managers to beat their benchmark. Correlation data undermines the assertion that ETFs are to blame, as S&P 500 correlations rose during the Global Financial Crisis and during subsequent macroeconomic or geopolitical events, but have fallen materially in the post-crisis environment despite the increasing usage of ETFs.
Active managers can preserve value in a down market, or rotate to favorable investments in a volatile market: There is intuitive appeal to arguments that active managers have a greater ability to protect downside in a bear market or rotate to more favorable segments of the market in volatile times. Interestingly, the technology bubble and global financial crisis occurred despite the dominance of active managers during both periods. Studies by researchers such as Morningstar and S&P demonstrate that in many asset classes, active funds lag in performance relative to their index. Often the funds that beat the index do so by a margin that may not justify the additional cost, risk and tax consequences associated with active management. Compounding the frustration for many investors, it’s often the case that recent category leaders don’t continue to be leaders in subsequent periods.
The best managers have high “active share”: Active share is an interesting but frequently misused metric. Active share measures the degree to which a fund’s holdings differ from that of the index, and was devised in part as a way to expose funds that were “closet indexers,” charging active management prices for portfolios that closely resemble the benchmark index. Much of the active share research has focused on U.S. large cap equities, the most competitive area of the stock market and the segment in which “closet indexing” is most common. Active share is a good way to identify closet indexers, but isn’t necessarily predictive of outperformance. Although top performers in U.S. large cap may have high active share, it’s reasonably intuitive to conclude that bottom performers also have high active share!
Closet indexing is easy to implement in U.S. large cap, as nearly 20% of the S&P 500 Index is captured in the top ten holdings, and one-third by the top 25. The active share metric offers considerably less information in segments of the market that are less concentrated. For example, closet indexing approaches don’t work well for small company stock strategies, given the difficulty in replicating indexes that have very small concentrations in the top 10, 25 and 50 companies. “Top-heavy” indexes such as the S&P 500 index are much more likely to attract the closet indexing approach.
Expense ratios and manager tenure may play more of a role in explaining outperformance than active share metrics. Funds with low expense ratios and long manager tenures may tend to outperform funds with high expenses and less-tenured managers.
Many investors combine active and passive investment strategies, and are weary of the debate between the two. To investors who use both, the focus should be on how best to combine the two approaches. For that audience, a relevant question to answer is: “Which segments of the market favor active management approaches, and which favor passive approaches?”
Passive strategies may prevail in ultra-competitive segments of the market such as large cap equity, in which passive funds provide low-cost, tax-efficient market exposure. Active strategies may thrive in less efficient segments of the market, such as small-cap equity, in which company-level research can make a difference and skilled managers can develop a sustainable edge.
Active strategies are also compelling in segments of the market in which indexes are more fluid in nature, and today’s index may not fully represent tomorrow’s opportunities. For example, emerging markets indexes reflect economies that have been heavily weighted to banks, commodity producers, and technology companies. However, some of the most interesting future opportunities may be outside today’s indexes, in companies benefiting from the growth of the middle class in emerging markets and transition to consumer-led economies.
Active strategies may offer risk management benefits in segments in which indexes may have fundamental flaws. For example, indexes used for high yield are concentrated in companies that have issued the most debt, potentially creating an undesirable risk profile! Active managers may be better equipped to manage exposure to highly leveraged energy companies or risky sovereign borrowers in Europe or Emerging Markets.
Many of the active managers trying to hang on to market share, particularly in U.S. large cap equity, are likely to be fighting a losing battle to preserve revenues and high margins. At the same time, passive managers claiming to have the optimal solution for every problem may also be off base. The virtues of combining active and passive approaches to management are hard to ignore, as is the downside of “either-or” asset allocation approaches that exclusively employ one or the other. Strategies that exclusively employ active investments are typically more expensive, tax inefficient and may be more volatile than index-oriented strategies. Although approaches that exclusively utilize index or factor-based ETFs are increasingly in vogue, there are limitations to the all-index approach taken by ETF strategists. All-index approaches forgo the potential return enhancement provided by active managers in certain asset classes, while also diluting the impact of diversifying investments in asset classes that aren’t effectively represented by an index.
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