Will passive save active?

From

David Lafferty

This month, instead of a market rehash, we’ll turn to the ever-popular active vs. passive debate. Our objective is not to argue that one is better than the other – they both have merit within a diversified portfolio of strategies.

Instead, we’ll explore how the growth in indexing is (paradoxically) forcing active managers to up their game – a positive development for investors of all stripes.

While active managers have always competed against each other, they have never had to confront a threat of this magnitude. But in a strange irony, the pressures emanating from cheap passive strategies may ultimately save the active management industry.

As Darwin demonstrated, the most adaptable species are the ones that ultimately survive.

In this case, passive investing is forcing changes to active management that are long overdue. We see five trends that should bode well for active managers who are best able to adapt in the coming years.

#1: Lower Fees, Better Performance

First, and most obvious, indexing is forcing active managers to reassess the competitiveness of their fees. Going forward, active managers will have to better align their fees with their ability to generate excess return. These downward adjustments will, by definition, improve net performance (ceteris paribus). Regulatory changes also play a role. Directives like RDR in the UK and proposed fiduciary rules in the US are forcing fund buyers to purchase lower-cost share classes with many of the extraneous expenses eliminated.

#2: Lean and Mean

On top of improved performance, a closer eye on costs could bring additional benefits. We believe lower fee revenue will result in an era of increased discipline and efficiency for active managers. Over the years, high profit margins across the industry have allowed the focus of active managers to wander. Many overinvested in areas of the business unrelated to generating alpha, but as margins shrink, the days of industry giveaways and boondoggles are likely numbered.

#3: Death of the Closet Indexers

A greater focus on generating excess return will naturally drive managers to create more differentiated portfolios. As early as the 1980s, institutions began to recognize that portfolios could be made more efficient by separating cheap beta from expensive alpha. Today, even retail investors understand the perils of benchmark hugging and overpaying for beta, and are gradually forcing the closet indexers out of business.

#4: Is Anyone Paying Attention to Fundamentals?

A fourth consequence of the growth in passive investing is an increasing misallocation of capital. Counterintuitively, indexing may be creating greater opportunities for active managers as more capital is put on autopilot without regard to asset quality. Today, the majority of indexed assets are simply allocated based on market capitalization (for stocks) or issuance size (for bonds). No distinction is made regarding companies’ fundamentals, valuation, risk, or governance practices. While investors can expect markets to remain reasonably efficient,
the surge in indexed assets can create larger pockets of mispriced securities.

#5: The Perils of Autopilot

Finally, some active strategies stand to gain from one of indexing’s inherent weaknesses: the inability to manage risk. The major market-cap and issuance weighted indexes are fully invested at all times and provide pure beta, delivering all of what the market provides, good and bad. Since 2009 this has been a boon for passive strategies, as global stocks have risen while declining interest rates bolstered bonds.

Wake-Up Call

None of these factors, individually or in aggregate, insures that the average active manager will beat the index or outperform net of fees. However, the pressures exerted by passive indexing are forcing active managers to tackle longstanding sources of inefficiency and underperformance. By setting more appropriate fees and weeding out closet indexers, active strategies should rise in the competitive rankings. Moreover, the wake-up call of the next bear market will force investors to be more discerning about the quality of the assets they own, pushing many of them towards strategies that can better manage risk. Instead of complaining, active managers should embrace the changes occurring in the asset management industry. In the long run, the competitive pressures of passive indexing may save active management.

By David Lafferty, Chief Market Strategist

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