Joseph Mariathasan: Can active management survive?
The challenges faced by traditional fund mangers aren’t going away any time soon, writes Joseph Mariathasan
The proposed merger of Henderson Global Investors and Janus Capital is another example of the consolidation we are seeing in the investment management industry. Traditional fund managers face serious problems if they hope to survive, let alone prosper, over the long term, as they face challenges from passive, smart beta and active quant products. These competitive pressures, combined with a low-return environment, have led to the fee cuts that lie behind the consolidation. These pressures are not going to lessen in the foreseeable future.
It’s no surprise that passive management, smart beta strategies and quantitative active management are all making strong inroads into the equity space. Smart-beta approaches appear to be able to add value to lower-cost passive market capitalisation approaches. A lot of studies show that virtually any kind of alternative weighting can beat passive market-cap-weighted indices. Smart beta can incrementally improve returns available through purely passive strategies because the tilts that such strategies introduced have proven over the long term to be effective. Factors such as value, quality, momentum and low volatility have roots in behavioural finance, with evidence through back-tests showing that they work over long, statistically significant periods of time. The argument goes that, because they are behaviourally backed, and human beings do not change behaviour very quickly, they should continue to work into the future.
The worry about smart-beta strategies is that they are created using pretty naïve factors. Smart-beta approaches typically use simple constructs. What quant then does is to use that same philosophical backing but puts it together in a far more sophisticated manner. For investors seeking small-cap managers, the universe of 2,500 or so stocks in just Europe in an illiquid, poorly researched market is difficult for fundamental managers to tackle, and few have tried. An active traditional manager may have around 60-80 stocks in their portfolio. In contrast, a quantitative approach has no restrictions on the number of stocks that can be analysed in a consistent manner, but the portfolios will typically have many more stocks in them, as the conviction associated with any specific bet is much less.
Given the increasing competition from passive, smart beta and quantitative approaches, fundamental managers need to be able to articulate why their process works and why it should continue to work into the future. The days of earning a living by closet indexing may be coming to a close, but how many active managers are actually prepared to take a forward-looking view completely independent of their benchmark index weightings? If systematic alternatives can be bought very cheaply, what can a fundamental active manager do that will improve returns?
Typically, a fundamental approach can pick out problems in the balance sheet that a systematic approach may be unable to do. They may be able to have a forward-looking view that can take advantage of macro-economic factors. What quant and smart beta cannot do is to produce high-conviction portfolios. For investment consultants, that means managers able to run portfolios of no more than 30-50 stocks, and one admitted that they would rule out any fundamental active manager with a 100-stock portfolio on the grounds that no one can really know them all well. That does leave opportunities for many active fundamental managers but maybe not the majority.
Joseph Mariathasan is a contributing editor at IPE