Alfred Slager argues that active management still has a place as an effective investment strategy but with new metrics, better data and innovation by managers
At a glance
• The shift towards passive management seems to indicate that trustees do not value the knowledge gleaned by active managers particularly highly.
• Many active managers are likely to disappear in the coming years as a result of overcrowding in the market.
• However, there are opportunities available for active managers who are willing to move away from the traditional approach of beating benchmarks.
• Success for active managers will involve developing new metrics and other innovations.
Active management seems to be under threat. Poor performance in relation to the benchmarks, the rise of smart beta, which promises better risk-adjusted returns for investors with less hassle, and the continuing pressure to provide more transparency on costs bring home a simple message to trustees: go with passive. Reports that active management is dead might be exaggerated but there is no denying that the sector has a problem. What is a sensible approach for a trustee to take?
The active-passive debate seems like a technical squabble with finance academics going back and forth over the efficiency of markets. But the topic is also at the heart of a trustee’s responsibility where it relates to what is known as the principal-agent problem. Trustees as principals are the (delegated) asset owners but they lack an in-depth knowledge of the financial markets. As a result they appoint agents, the asset managers, who have knowledge about the financial markets but lack the assets.
Asset managers seek to optimise this difference in knowledge in the form of fees, while trustees have an interest in keeping costs low. Trustees deliver a double blow when they shift assets from active to passive. Such moves signal that trustees do not value knowledge of the financial markets particularly highly. This is a difficult message for asset managers to take, as it suggests that years of craftsmanship have been wasted. The second blow hits the earnings model of the investment industry. Changing from active to passive means fewer transactions, less fee income and reduced employment.
So there is always a strong emotional and financial incentive for investment managers to convince trustees that this shift might be a bad one. Active investment managers have theory on their side but must deal with day-to-day practice as an inconvenient truth.
“The concern for funds today is not that the strategy beats its benchmark but whether active management is relevant to achieving the pension funds’ goals”
For a start, there are ample active management opportunities, in the following way: a researcher stumbles upon an interesting pattern, either through diligent database research or observation of a successful investment manager. After publication, other researchers follow suit; a new investment strategy is born and, subsequently, new variants are introduced. A few years later, some new (meta) research emerges. It becomes apparent that the investment strategy, corrected for risks and costs, is subject to the usual return/risk tradeoff that has been apparent since the 1970s.
Have investment managers been untruthful to trustees? Not at all. Trustees, as well as investment managers, love an innovation. But most innovations simply fail. There are many reasons. Generally the hurdle to introduce an investment strategy is quite low. We are not able to test a strategy in a (clinical) environment with a test group to find out how the environment or trustees respond. Worse, the quality measures that are used before agreeing that a strategy can be applied in practice, measured, for example, in terms of statistical significance, are far lower than in medicine or in consumer goods. Food safety and health deal with far higher quality standards but our pension health can apparently get by with lower standards.
The real problem, however, as investment author Charles Ellis points out, is that there are simply too many successful investment managers. The number of talented investment managers has grown faster than the number of investment opportunities. It does not require much imagination to realise that alpha, whatever its size, is being shared between too many parties. As a result, the marginal benefits of active investment strategies are reduced.
Trustees are left with two choices. They can try to time the new strategy in the hope that other funds have not seen this opportunity yet (an approach bordering on wishful thinking). Alternatively, they can try to resist the temptation to apply a new active strategy (running the risk of being viewed as lagging).
How should this debate proceed? Active management is a broad brush, so trustees are increasingly differentiating the active-passive debate and applying it for their own purposes. The concern for funds today is not that the strategy beats its benchmark but whether active management is relevant to achieving the pension funds’ goals.
Developing a framework that readjusts the risk budget depending on the cover ratio and volatility is such an approach. Tactical asset allocation as a form of active management is on its way to being replaced for something more relevant.
Another interesting development is benchmark construction. If active management means reconstructing the benchmark, trying to achieve effective diversification by getting to know the underlying risk factors, this is a promising avenue. Smart beta as a form of active management then adds to a pension funds’ goals. If smart beta were to be positioned and further developed as an active investment strategy compared with the market-weighted capitalisation benchmark, then its added value could be questioned.
Active management gets trickier when it comes to themes like long-term investing. The approach has gained a lot of traction and seems to be presented as the panacea to what is wrong in the financial markets. Conceptually, long-term investing is a valuable addition to the investment management framework if it helps to create new markets that are beneficial. A trustee should become suspicious if the debate about long-term investing centres on relaxing investment restrictions lengthening the evaluation horizon, or loosening monitoring. Long-term investing is then misused as an argument to strengthen the asset managers’ position in the principal-agent dilemma mentioned earlier.
Finally, one should not be surprised by the disappearance of many traditional active funds and strategies in the coming year as a result of overcrowding. This is also where much of the publicity on disappointing results is focused. Trustees will find active management to be less relevant to the pension funds and too time-consuming in terms of monitoring. Its cost base and organisational requirements make it harder to align with today’s demands. The time has come to close this chapter.
So there is both good and bad news for active management from a trustee perspective. The bad news is that the classical beat-the-benchmark game is on its way out. The good news is that there are three opportunities that should be grasped with both hands.
First, active managers could work on developing a new set of metrics. What sort of strategy would best aid the funds’ goals? Which risk factors would one add compared with the total portfolio? In other words, the ability to link a fund to particular objectives should shape future investment strategies.
Second, trustees could spur this development by setting up data rooms for investment managers. The classical, highly bureaucratic, request for proposal could be replaced by the opportunity for active managers to present truly relevant business cases for their active management strategies. Building effective long-term relationships would be a positive side effect.
Finally, active managers could innovate on testing strategy introduction. How could we emulate prototyping, testing and introduction of a new strategy in such a way that it filters out the mediocre ones from the start? To move from classical database back-testing to live simulation raises the hurdle but increases the chances of durable investment strategies and of developing long-term partnerships. Trustees no longer need to be drawn into overly technical asset-pricing discussions but can focus instead on what matters – assessing where active management can work.
Alfred Slager is a professor at the TIAS School for Business and Society in the Netherlands and a trustee of SPH, the Dutch pension fund for general practitioners
Special Report Active Management: The active game
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The trustee perspective: active manager still has a place