Will Passive Save Active?

Indexing Raises the Bar

This month we’re taking a break from global economics and capital markets for several reasons. First, our views have been well-covered in this space in recent months. That is, that risk assets will continue to grind higher as long as the synchronized global expansion remains on track. Investors should temper their expectations, however, as valuations across stocks, sovereign bonds, and credit remain elevated. Simply put, fundamental strength will exert upward pressure on assets, but the upside is probably limited longer term because no broad asset classes are cheap. Second, little has changed in the big picture over the recent months. The global expansion, slow normalization from central banks, the on-again-off-again love affair with US tax reform, growing geopolitical risk, and challenging valuations still define the backdrop for global investors.

This month, instead of a market rehash, we’ll turn to the everpopular active vs. passive debate.

Our objective is not to argue that one is better than the other – they both have merit within a diversified portfolio of strategies. Instead, we’ll explore how the growth in indexing is (paradoxically) forcing active managers to up their game – a positive development for investors of all stripes.

Active Adaptation

Times are tough for active managers. Regulation, transparency, and cost sensitivity have conspired to shift trillions of dollars from active investment strategies to passive indexing. By most accounts, the outlook for active investing is challenged, as investors are losing patience with active managers’ prolonged streak of underperforming the major indexes. In addition, many of these managers continue to charge fees that are significantly higher than those of the passive alternatives. After 35+ years of beta-driven returns generating abnormally high profit margins across the industry, the combination of charging more and delivering less finally looks unsustainable.

These are strong headwinds. While active managers have always competed against each other, they have never had to confront a threat of this magnitude. But in a strange irony, the pressures emanating from cheap passive strategies may ultimately save the active management industry. As Darwin demonstrated, the most adaptable species are the ones that ultimately survive. In this case, passive investing is forcing changes to active management that are long overdue. We see five trends that should bode well for active managers who are best able to adapt in the coming years.

#1: Lower Fees, Better Performance

First, and most obvious, indexing is forcing active managers to reassess the competitiveness of their fees. Going forward, active managers will have to better align their fees with their ability to generate excess return. These downward adjustments will, by definition, improve net performance (ceteris paribus). Regulatory changes also play a role. Directives like RDR in the UK and proposed fiduciary rules in the US are forcing fund buyers to purchase lower-cost share classes with many of the extraneous expenses eliminated. In the US, high fee B-shares died several years ago, while sales of the once popular C-shares are moribund. The truth is that many of these share classes had total expense ratios high enough that long-term outperformance was unlikely. The industry’s movement toward lower cost appears well under way.

A recent study by FUSE Research Network notes that average fees for active equity funds have fallen from 0.92% to 0.75% over the past ten years – a 18% drop. As active managers continue to cut fees and investors demand more stripped down share classes, fewer structural laggards will be left in the active universe.

#2: Lean and Mean

On top of improved performance, a closer eye on costs could bring additional benefits. We believe lower fee revenue will result in an era of increased discipline and efficiency for active managers. Over the years, high profit margins across the industry have allowed the focus of active managers to wander.

Many overinvested in areas of the business unrelated to generating alpha, but as margins shrink, the days of industry giveaways and boondoggles are likely numbered.

Revenue pressures will force active managers to streamline and focus squarely on activities that seek alpha. They may increasingly turn to new technologies to reduce labor costs and seek performance consistency. If adopted, smarter trading and more efficient use of quantitative techniques should lead to lower expenses and more competitive returns.

#3: Death of the Closet Indexers

A greater focus on generating excess return will naturally drive managers to create more differentiated portfolios. As early as the 1980s, institutions began to recognize that portfolios could be made more efficient by separating cheap beta from expensive alpha. Today, even retail investors understand the perils of benchmark hugging and overpaying for beta, and are gradually forcing the closet indexers out of business. As investors barbell between low fee beta and higher fee alpha, the active funds that remain will be more concentrated and have less benchmark overlap. While this “high active share” alone may not be sufficient to generate excess return, it is certainly a necessary condition.

As a result, fewer strategies that are structurally unable to outperform their expense drag will remain in the databases. Like lower fees, this third trend will also improve the relative performance of active managers compared to their benchmarks.

#4: Is Anyone Paying Attention to Fundamentals?

A fourth consequence of the growth in passive investing is an increasing misallocation of capital. Counterintuitively, indexing may be creating greater opportunities for active managers as more capital is put on autopilot without regard to asset quality. Today, the majority of indexed assets are simply allocated based on market capitalization (for stocks) or issuance size (for bonds). No distinction is made regarding companies’ fundamentals, valuation, risk, or governance practices. While investors can expect markets to remain reasonably efficient, the surge in indexed assets can create larger pockets of mispriced securities. Again, there is no guarantee that the majority of active managers will be able to systematically take advantage of these pricing inefficiencies. However, for active managers skilled enough to capitalize on it, opportunities to generate alpha are likely to increase.

#5: The Perils of Autopilot

Finally, some active strategies stand to gain from one of indexing’s inherent weaknesses: the inability to manage risk. The major market-cap and issuance weighted indexes are fully invested at all times and provide pure beta, delivering all of what the market provides, good and bad. Since 2009 this has been a boon for passive strategies, as global stocks have risen while declining interest rates bolstered bonds. But at some point the bear will return, and when it does, investors will rediscover the darker side of holding assets on autopilot. While there is no guarantee that active strategies on average will outperform the indexes in the next big selloff, these managers at least have the ability to de-risk during periods of trouble.

In the next bear market, many investors who have been spoiled by full upside participation will come to realize the pain of full downside exposure. As with planes and self-driving cars, enthusiasm for autopilot may wane after the first crash.

This may be when investors develop new respect for the segment of active strategies that can offer some downside protection that the indexes, by their very nature, can’t provide.

Wake-Up Call

None of these factors, individually or in aggregate, insures that the average active manager will beat the index or outperform net of fees. However, the pressures exerted by passive indexing are forcing active managers to tackle longstanding sources of inefficiency and underperformance. By setting more appropriate fees and weeding out closet indexers, active strategies should rise in the competitive rankings. Moreover, the wake-up call of the next bear market will force investors to be more discerning about the quality of the assets they own, pushing many of them towards strategies that can better manage risk.

Instead of complaining, active managers should embrace the changes occurring in the asset management industry. In the long run, the competitive pressures of passive indexing may save active management.