Pension funds: the active versus passive dilemma

Brendan Maton finds the role of asset managers is in the spotlight as institutional investors question whether active asset management achieves better results than passive strategies  

At a glance 

• Passive investment can perhaps best be seen as a form of rules-based strategy.
• Almost all rules-based strategies not led by market capitalisation will diminish the influence of size and growth.
• ‘Passive unless…’ is fast becoming an investment principle in the Netherlands.
• The current stage of the investment cycle could favour active managers.

In any debate, it never helps for an expert to change the terms before the arguments really get going. But when it comes to active versus passive investing, this is exactly what Andrew Clare, professor of asset management at Cass Business School in London, does.

“There is no such thing as passive management,” he says. For Clare, all the technical rules that go into the construction of a securities index give it a particular character and biases. These might be extremely helpful to investors, such as a desire for liquidity or tradable stocks, but they should not confer a sense of pure objectivity, neutrality or efficiency. Few indices replicate perfectly the market they represent.

Therefore, Clare prefers to label funds and mandates that track market-cap indices rules-based strategies. And this blows open the active versus-passive-debate because many investment strategies are also rules-based. The newest of these are better known as factor or smart beta strategies.

Amundi, AXA Investment Managers, Global Wealth Allocation, HSBC Global Asset Management, Northern Trust Asset Management, Ossiam, Quoniam, Research Affiliates, Robeco and THEAM, are just some of the purveyors. Some rely on risk premia while others, such as TOBAM, rest on formulae for risk diversification. 

But most of this crop of rules-based strategies offer themselves in the form of an index. If they are rules-based and the market-cap indices are rules-based, perhaps the debate should be between discretionary investment management and rules-based approaches rather than active versus passive.

One can look at market-cap tracking for the biases it brings in much the same way that one has to look at factor-index tracking for their biases. Some pension funds do not want to undertake this analysis – partly a reaction to hyperbolic marketing of smart beta; partly from fear of statistical analysis. These asset owners want to believe the market cap index is neutral and, as a benchmark, something merely to be beaten or tracked without investigation of its own nature. 

They are stuck in the simpler world of alpha/beta separation: the market represents beta for them; any outperformance counts as alpha.

Philip Menco, former CIO and CEO of De Eendraagt pension fund in the Netherlands and now a pension fund adviser as head of Fortunis consultancy, is certainly not in this camp. A big supporter of systematic strategies, he has long analysed how quantitative methodology might provide superior strategies: “Indeed, since my first day in asset management, in 1981, when my boss told me that the market cannot be beaten.”

In his time, Menco has been involved in the appointment of discretionary managers. He says that some indices in equity and fixed income are more easily beaten than others – emerging markets is a good example for both asset classes (see panel: Active and passive: pros and cons). 

But in more efficient markets such as western Europe and the US, Menco turns to factor decomposition to explain standard indices – and beta alone is not the only factor he finds.

“The S&P 500 gives you exposure to the growth and large-cap factors,” he says. “In a raging bull market like the late 1990s, it is almost impossible to beat.”

Forthcoming analysis by Clare and colleagues at Cass Business School backs Menco up. Sorting the US equity market into deciles according to market cap and, separately, book-to-price, they find that over 45 years, the average weight of the top 50 stocks in the S&P 500 was almost 50%, in contrast to the bottom decile which was 2%. 

By book-to-price, those 50 stocks with the highest book-to-market value made up just 6.1% of the index. Those 50 stocks with the lowest book to market values made up 12.4% of the index. The Cass academics conclude that not only is the market cap index concentrated in ‘mega stocks’ but also tends to exhibit a tilt away from value towards  growth stocks. 

Almost all rules-based strategy not led by market capitalisation will diminish the influence of size and growth. One of Fortunis’ clients is the PNO Media pension fund, which has adopted a home-brewed equal weighting strategy for both European and US equities. While the portfolios are not as broad as standard market-cap indices for these regions for reasons of liquidity, equal weighting is one of the clearest means of diluting the risk of ‘glamour’ stocks by means of mechanical, regular but infrequent rebalancing.

The £13.5bn British Steel Pension Fund also has an equal-weighting strategy for its core Japanese allocation. Hugh Smart, CIO, recalls that over the long term the fund has implemented various strategies in Japan. His observation was that of the 1,900-plus stocks in the TOPIX, just 10% accounted for about 75% of the total market capitalisation. The British Steel Pension Fund’s mantra is ‘home cooking is best’, so it devised and implemented the stratified equal-weighting strategy itself and is extremely pleased with the results.

But here we come to another confusing juncture in the active versus passive debate. The British Steel Pension Fund in most other regions uses active management. It has, for example, an in-house UK equity portfolio that has eclipsed the FTSE All-Share every year over the past 11 years, even though the UK equity market is usually considered efficient. 

Style eclecticism clearly works for many large funds such as British Steel. Another practitioner is the Swiss Railways Fund, PKSBB, run by Markus Hübscher, a veteran in passive management at iShares and before that Credit Suisse’s exchange traded fund (ETF) business. In spite of his pedigree and belief in passive management, the CHF16bn (€14.7bn) fund retains – among other active briefs – an externally managed North American small-cap portfolio that Hübscher ‘inherited’ when he joined six years ago. Just like British Steel’s UK equity mandate, the railways fund’s experience has been so positive that the mandate remains in place.

In the Netherlands, Rob Oosterhout, chair of the investment committee of the €25bn ING pension fund, says that one of its investment principles is ‘passive unless’.

This is fast becoming the standard in the Netherlands, regardless of the size or capability of a pension fund, because of the insistence on cost transparency and accountability by the regulator, the Dutch central bank. 

Median manager performance

Nevertheless, the ING fund has given money to three specialist active managers in north American equities whose returns net of fees have been flat over three years. How to reconcile the ‘passive unless’ principle with a roster in a stock market Oosterhout himself describes as efficient?

Oosterhout says that there is always room for truly active managers that act as genuine long-term owners and deeply understand the businesses in which they invest. But even sophisticated funds like ING do not have certainty over how long it takes for their own commitment as a client of such active strategies to be repaid. The managers themselves emphasise stock selection as the source of their outperformance.

Style eclecticism as practised by the largest pension funds has clear benefits but it has to be implemented and maintained with care. Part of the quandary for smaller pension funds considering such eclecticism is where they should implement rules-based strategies and where discretionary. They want diversification not ‘di-worsification’.

One possible answer to the conundrum comes from analysis by INTECH, available as a white paper on IPE’s Reference Hub. Authors Richard Yasenchak and Valerie Azuelos suggest that active management – quantitative or discretionary – does not do well when markets perform really well. 

Their analysis shows that over rolling three-year periods going back 20 years, the median large-cap manager outperforms the market when US equities achieve an absolute annualised performance of 11.1% over three years. For global equities, the threshold is 12.2%. As every investor well knows, from 2012-14, both indices delivered far higher returns. And so, the Intech findings echo Menco’s observations on the nature of the S&P500 – when on a bull run, it is almost impossible to beat.

Yasenchak and Azuelos conclude: “Given where we are in the active-management cycle and following the very strong performance of equity markets, it may be short-sighted to make an active decision to exit active management at this time. As long as the confidence in a manager’s investment process, team and alpha source remains strong, a shift to passive could impede any recovery once the manager’s investment process is back in favour.”

This conclusion may assuage the current fears of pension fund clients of active equity specialists, wondering whether to get rid of them, given that the markets have delivered far in excess of these figures in recent times. It is a fair warning. 

But then the abiding question for pension funds is when to return to passive management the next time round. Like all quantitative analyses, these findings are most effective when applied to the past. Economic, capital market and ‘active management’ cycles have one thing in common – they are frustratingly irregular, which may be why the active versus passive debate will live on.

Active and passive: pros and cons

Asset owners often use active management in minor securities classes and emerging markets because they are convinced that in these regions the benchmark securities index does not well represent the underlying market.

This argument is far less common when it comes to developed, informationally efficient markets.

But there is no universal agreement on where the dividing line falls. The CHF16bn Swiss Railways pension fund (PKSBB) has opted for an active manager in US and European high yield based on analysis of benchmark indices.

Markus Hübscher, chief executive of PKSBB, said its research found that active managers had a wider universe and are therefore measured against broader indices. For the US, the fund has selected the Barclays Capital US High Yield 2% Issuer Capped index as its benchmark. For Europe, the benchmark is split 50/50 between the Barclays

Pan European HY 2% Issuer Capped index and the Barclays Pan European HY 2% Issuer Capped excluding Financials index.

PKSBB’s research found that passive products are affected by liquidity constraints and have to use much narrower and more liquid indices. Hübscher told IPE that the indices by passive managers have significantly lower risk-adjusted returns over a longer time horizon. In other words, an active manager does not even have to beat its benchmark in order to outperform passive managers in high yield. 

The Swiss Railways fund’s analysis accords with the latest Insight survey from global investment consultancy, Mercer, which looks at returns for 87 US high yield managers over five years to the end of September 2015. The index return would have been the 66th manager in that universe. This suggests that a fund or adviser only needed to pick one of the top 75% of managers in the universe (66/87) to have beaten the index.  

One reason why so many active managers have been able to outperform is the index’s relatively high weighting of issues from the energy sector, which has been heavily hit by the slowdown in commodities and concerns about the growing pains of US frackers.

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