Pragmatism redefines active-passive
With investors losing trillions in the 2007-09 bear market, they are questioning whether active management delivers value. In the process, they are also recognising that active and passive management are but a means to an end. What really matters is the client's own investment philosophy and the combination of active and passive strategies that is consistent with it.
While the history of the Dow Jones industrial average dates back to 1896, the initial conception of an index was as a market proxy, not an investment idea. But, indices have become investments over the past 30 years.
According to a forthcoming study from CREATE-Research a minority of active managers deliver market-beating returns net of fees. Hence, we recently convened with four managers to revisit the active-passive debate and understand how their clients are responding.
Proponents of active management claim that the skill of certain investors is undeniable. As Tad Rivelle, CIO, fixed income for TCW, asserts: "Consider Warren Buffet: is it really just 40 years of lucky guesses for him?" True, the list of active managers who have beaten their benchmarks ten calendar years running is a short one, yet a much longer list have bested their index over cumulative periods. Meanwhile, the median manager routinely outperforms the benchmark in niche asset classes, such as small cap equities.
Flawed construction is also cited as a limitation of passive management. Major fixed income benchmarks cover hundreds of securities, many of them illiquid, making it challenging for passive managers to fully replicate the index. For some global equity investors, the benchmark "does offer a reference point, but a strangely constructed one," according to Silk Invest CEO Zin Bekkali.
He notes that one frontier market index allots three times the weighting to Kuwait (population of three and a half million) as to Nigeria, considered ‘the Brazil of Africa', with a 150 million population. Indeed, the recent decision to rebalance Apple's weighting in the NASDAQ 100 from 20% to 12% creates the type of arbitrary noise that active managers welcome.
Globally, active management accounts for nearly 90% of assets under management; this imbalance suggests that active management has more believers than sceptics. "With a vast industry of active management serving clients, it is hard to argue that it doesn't exist for a reason," notes Mark Burgess, CIO of Threadneedle.
Yet, the landscape is becoming more polarised, with today's ratio of active-to-passive management reflecting a legacy, rather than a direction. Lower expected returns have led investors to explore low cost solutions like exchange-traded funds (ETFs). At the same time, active managers were exposed, either as closet indexers (in the case of mutual funds), or leveraged beta plays (in the case of hedge funds). Going forward, managers will be increasingly asked to choose between delivering low cost beta or repeatable alpha within a cost-efficient fee structure.
This choice is being dictated by three considerations on the part of investors:
• What liabilities am I trying to fund?
• What level of illiquidity am I comfortable with?
• What resources do I have for risk management and oversight?
Many clients who believe markets are inefficient will seek out the purest form of alpha through hedge funds. Yet, as became clear in 2008, investing in alternatives requires significant time and resources: investment due diligence must be augmented with operational due diligence (including counterparties). Clients must also consider how much liquidity they are prepared to sacrifice.
If these considerations are too burdensome, Alan Brown, group chief investment officer at Schroders, offers that "for a pension fund with a limited governance budget, passive management is not a bad place to be." While investors still need to study the mechanics of index construction, plain vanilla, long-only indices are easy to understand.
The decision process doesn't end there. As our case study shows, investors' approaches are becoming highly eclectic: they hedge the risks which are not rewarded; they separate alpha and beta; they separate ‘buy and hold' from opportunistic investing. Market returns are the core component of beta strategies. For their non-beta needs, however, an excess over cash or liabilities are the key targets.
In order to diversify risk, secure cash flows, or produce higher rates of return within this new approach, clients are increasingly embracing a blend of strategies - active, passive, and alternative - rather than asserting one approach's superiority.
Having made investment choices, the ultimate challenge is sticking to their plan. Studies have shown that clients typically sell low and buy high, particularly in the face of volatility. "Humans weren't designed to make sense; we were designed to survive," says Rivelle When the lion is about to eat you, you lose your wits." This behavioural line of thinking argues that investors are hard-wired to repeat their mistakes.
Investors' poor market timing also creates problems for managers. An investment thesis unfolds less like a horse race, and more like a nurtured garden. "You have to let time play its part and not run for the hills every time markets head south," says Brown. And despite the recent rash of tactical products, Bekkali argues that "sticking to long term strategic weights, especially in emerging markets, will avoid buying high and selling low".
In any event, the active-passive debate has raged on for years. How might asset managers better engage with clients increasingly embracing solutions-driven investing?
Burgess suggests beginning with realistic three to five-year targets of what they can expect from a given strategy. "I think all clients like honesty," he observes. "If you're clear with your messaging, perspective and process," he continues, "you can be given more latitude when underperforming."
Equally important, clients must be honest with themselves. Identifying their own philosophy before that of their managers seems like the best place to start.
Neeraj Sahai and Benjamin Poor are respectively global head of securities and fund services and manager of market intelligence at Citi Securities and Fund Services. Views expressed in this article are those of the managers and are not necessarily those of Citi or any Citi entity or business.