Active Management: The active-passive debate
Daniel Ben-Ami finds the role of asset managers is under continuing scrutiny as the investment industry continues to question whether active asset management can achieve better results than passive strategies
At a glance
• The active-passive debate raises fundamental questions about the role of asset managers.
• There is strong evidence questioning the ability of active equity managers to outperform indices through the use of skill.
• It may be that behavioural biases explain why active management retains widespread support among investors.
• The most fundamental question, from a pension fund perspective at least, is whether the debate is of great importance.
What has become known as the active-passive debate is now a foundational discussion within the investment industry. It raises fundamental questions about the proper role of asset managers. Should they be using their superior skill to outperform the market or should they accept the more modest role of simply tracking indices?
The debate has raged for much longer than even most industry professionals realise. Against the Gods, a seminal book by Peter Bernstein on the history of financial ideas first published in 1996, recounts how Alfred Cowles had a study published on the subject in 1933. The wealthy investor and amateur scholar concluded that financial trading results from insurance companies “could have been achieved through a purely random selection of stocks”.
Of course, things have moved on considerably since then. For example, on the passive side the focus is no longer overwhelmingly on those who simply track stock market indices. Many others have constructed indices using alternative criteria such as ranking constituents by book value or sales. Sometimes such approaches are described as smart beta. Here the implication is that the market return – beta – can be captured more intelligently than through simply tracking standard market indices.
There is also a wider range of vehicles available to pursue passive strategies. In addition to conventional tracker funds, the amount invested in exchange traded funds (ETFs) has surged in recent years. Not all of these can be described as passive but many of them are.
However, innovations are also apparent in the active sphere. The concept of active share has been developed as a way of gauging how much an equity fund’s holdings deviates from a benchmark. It is a way of gauging funds that are genuinely active and those that are often derided as closet trackers. The latter are essentially funds which charge active fees but offer portfolios that differ little from their respective benchmarks.
Many active managers also claim that current circumstances favour their approach. It is widely accepted that ultra-low interest rates and quantitative easing (QE) have pushed up asset prices. Under such circumstances, so the argument goes, the time could be ripe for active managers. They can pick stocks which are reasonably valued and avoid the bloated behemoths in the market.
This special report examines all of these threads in more detail. It canvases the opinions of asset managers, pension fund trustees, consultants and other experts to assess their stance on the subject. Many of these are supporters of active management while others are critical. It is up to you, the reader, to decide who makes the most convincing case.
This introductory article will make a sceptical start. It will first canvass the views of three academic experts on investment – although all of them also have professional contacts with the financial industry.
Perhaps the best place to start is with Burton Malkiel. The emeritus professor of economics at Princeton has some claim to be the doyen of active management sceptics. A Random Walk Down Wall Street, his influential book on the topic, was first published in 1973 and has gone through 15 editions. For many years he was also a director of the Vanguard group, the US mutual fund giant that specialises in passive investing.
Malkiel, now 83, is unrepentant in his belief in the virtues of passive investing. “If anything, I believe more strongly in the passive side than I did in 1973 when I first wrote my book,” he says. “I think the evidence is really overwhelming. It is harder and harder for active managers to outperform and the data supports that in the United States, in Europe and even in the so-called inefficient emerging markets.”
At the same time, the cost of passive investing has come down even further. It can be as low as a few basis points to invest in a broadly based tracker or an ETF. Costs in the US, which has the benefit of huge economies of scale, are generally lower than in Europe.
Malkiel has no truck with those who argue that passive funds will, by their nature, invest too heavily into the most over-valued stocks. “I think it is misleading and inaccurate,” he says. “Let’s take a look at what has happened in the United States in the index arena. A stock whose market capitalisation has doubled and is the largest stock in a total stock market index is Apple. Apple is arguably one of the most reasonably priced stocks.”
He does make the small concession that this criticism could have held weight during the height of the dot.com boom. “Maybe you could have made that argument during the internet bubble in late 1999 when Cisco sold at 150-times earnings,” he says. “But if you look at the situation today and you look at the securities that have the most weight, they don’t seem to have valuation metrics that are very different from others.”
In any case, he says that active managers have generally failed to take advantage of these alleged valuation anomalies. “If it were true, then why is it that when you look over the last several years that it isn’t two-thirds of the managers that are outperformed by the index but more like 80-90% of the managers.”
Even in the case of emerging equity markets, which are generally viewed as less efficient than developed markets, he says that passive managers generally outperform. He says the only exceptions he has found are the local markets in China. But in such cases, where insider trading is claimed to be common, it is clear why active managers should have an advantage. Since such practices are illegal in most markets, it is not an example to be replicated.
Malkiel is keen to point out that some pension funds at least are distancing themselves from those who often claimed to be the most sophisticated investors of all – hedge funds. Investing in such portfolios often carried high fees but the results, Malkiel says, were often poor. “Pension funds which got quite enamoured with investing in hedge funds are now rethinking this,” he says. He points to CALPERS, the California state pension fund, which decided in 2014 to stop investing in hedge funds.
Outside of the equity markets, he accepts that there can be a case for active management. “If I wanted to buy a portfolio of commercial real estate I would say yes,” he says. That is because only a relatively small number of people would typically be examining each asset. In contrast, many thousands can be involved in analysing, for example, Apple stocks.
Alfred Slager, a professor at the TIAS School for Business and Society in the Netherlands and a trustee of SPH, the Dutch pension fund for general practioners, is of a different generation to Malkiel but he takes a similar view. He also accepts that the weight of academic evidence tends to support the case for passive investment in many areas. Although many investors have shifted in that direction, he argues that, if anything, it would be expected to have gone further. “Based on what we know, you would expect far more passive strategies than we see today,” he says.
This contention, of course, begs the question, if he is right about the benefits of passive, why is it not more popular among investors and pension funds in particular? Slager favours a behavioural explanation. “First of all, it is difficult for many trustees to avoid assuming that, if there are so many well-paid and well-educated asset managers out there, there must be active opportunities.” In addition, he points to the need to be perceived to be forward thinking and in control. “Active managers also promise to limit downside risks so [those who invest in their funds] can at least show the world they have taken an active stance towards these difficult markets.”
Slager is sceptical of the more recent innovations in active management. “If you look at those studies, they say you have a better chance on average that managers with a high active share will outperform,” he says. “The problem is, over what time horizon and what is the average?”
Andrew Clare is professor of asset management at Cass Business School in London and a pension fund trustee. He is more sympathetic to active management than the other academics quoted here but, if anything, his critique of the debate is more far-reaching.
Clare says the rise of smart beta products has made it necessary to move away from the traditional binary distinction between active management and index trackers. He argues that funds tracking market capitalisation-based indices are only one type of a more general rules-based approach to investing. “Market-cap weighted is just another rules-based approach to investing and it’s not the best one either in terms of performance,” he says.
As an experiment, he even devised a beta strategy that was weighted according to the rules of the Scrabble word game. “It outperformed cap-weighted by a country mile,” he says.
In his view, the range of investment products now available does not fit neatly into two distinct camps. “There is a whole spectrum of investing types along that rules-based versus discretion plane,” he says.
He also takes the view that at the active end of the spectrum some managers perform well. “I do believe there are good active managers out there but I think they are harder to find than a good rules-based passive strategy.”
The trouble is that the good active managers are difficult to spot. Even with the benefit of hindsight it is hard to tell whether a fund has performed well because of skill or luck. The ‘alpha’ that is often referred to as if it is a synonym for fund manager skill is at least partly the result of good fortune.
This observation leads him to a conclusion that active equity managers might find more difficult to accept than outright support for passive investment. Clare argues that, for many pension fund trustees at least, it is simply not worth the effort to start searching for the best active managers. Other decisions, particularly those relating to asset allocation, are likely to make a far greater difference to overall investment returns. “It’s not that I’m wholly against active equity investing,” he says. “It’s just the amount of difference it can really make is, for many trustees, not worth the time needed to monitor those things carefully.”
No doubt this view will jar with active equity fund managers. It is hard to imagine them not taking the position that they can provide a worthwhile service for pension fund investors. This premise provides the basis for their existence.
It is certainly the case that some pension funds see active management as worthwhile. Indeed, some of them are interviewed in this special report.
Nevertheless, the point about priorities is worth pondering. It is understandable that asset managers are fixated by the debate but it does not necessarily follow that it is hugely important for pension funds.