While the overall asset management industry has been growing along with passive investing, the share of traditional active funds has been declining, especially those operating in the developed markets of large-cap equity and government bonds. The global AUM share of traditional active products has fallen sharply over the past decade, from 60 percent in 2003 to around 40 percent at the end of 2014. Accompanying this dramatic change in flows has been increased speculation on the future of active management and the dynamics of active and passive investing.
Passive investing (specifically, using market-cap-weighted indices) is, in certain respects, based off the efficient markets hypothesis. In such a market, the simplest strategy would be to hold all the securities passively in proportion to their market cap. Ironically, market efficiency also depends on active managers doing research and identifying mispricing. The argument that is often raised is that as passive market cap AUM grows, an inflection point may occur where a particular market is dominated by market-cap-weighted investors. This may result in inefficiencies due to lack of research.
No one knows where passive investing’s inflection point is, or if it exists at all, but there are a few plausible reasons why the current exodus to passive products is not a major concern.
The relative turnover argument. Investment consultant Charles D. Ellis put forward the turnover argument: The price discovery mechanism, which keeps markets functioning efficiently, will probably be unaffected at even a high indexed point, as there is a massive difference in turnover between active and indexed funds. Currently index funds account for less than 10 percent of the annual turnover. With the reasonable assumption that the average active fund turns over 100 percent annually, then even in a scenario where index-based investing increases to 70 percent, active funds would still be carrying out 80 percent of trades, thus not damaging price discovery. In fact, to make turnover equal between an active fund and the buy-and-hold passive segment, the mix should be 90 percent passive and 10 percent active — a long way off from the current 20 percent to 80 percent mix.
It must be noted that the 10 percent turnover rate is for a passive fund or ETF when used as a buy-and-hold investment. This is in contrast to the usage of ETFs by the sell side and the buy side as rapid trading vehicles because of their superior liquidity. However, there is a clear distinction between such usages of indexing, which we classify as active, versus funds bought by the buy-and-hold investor.
Where is the flow to passive investment coming from? While it is true that passive funds are seeing high inflows, it is possible that a significant portion of those inflows is coming from declining benchmarked accounts and “closet indexers.” Research shows that the share of closet indexers has been steadily declining from 2005 to 2015, and under regulatory pressure, it is this segment of active management that will most likely face outflows in the future. Some studies have shown closet indexers to compose as much as 60 percent of active funds. It seems improbable that moving from implicit closet indexing to explicit index investing would affect much change in market efficiency.
Price setting depends on the existence of active managers, but a small number goes a long way. It is understood that active investors set prices through their trades and determine market cap — which the passive investor holds in his portfolio. Even if active managers focusing on security-level mispricings were a significantly smaller segment than currently, price setting would still occur when these active managers trade with one another, no matter the volume traded. Secondly, when a high proportion of investors are not specifically focused on company-level research and valuations, it is hard to conclude that their exit to indexing is anything more than a reduction of noise in the system. Markets could be equally well served by a smaller quantity of more focused investors setting prices.
CLEARING UP A POINT OF CONFUSION
On a separate note, as we discuss active versus passive investing, it is puzzling that investor herding issues are brought up so frequently in the context of passive market cap–weighted indices, when inflows to broad market funds do not change the relative pricing of a particular component sector or security. A passive market-cap-weighted fund could become “expensive” with too many inflows, but this is relative to other asset classes and market segments, and it does not influence the pricing of the largest constituents within the index any more than the smaller. Too many dollars chasing a particular asset — for example, emerging market equity, either in the form of active or passive products — will raise that asset's stock prices, but the decision of whether or how much to invest in that asset is an active decision in the first place. Active strategies (or even smart or hedge fund beta strategies) will be far more capacity constrained than market cap–weighted strategies, which actually allocate according to constituent capacity.
As investors become progressively more informed, it is possible that fund managers will eventually be rewarded only for returns that cannot easily be replicated by vanilla quantitative techniques.
Alpha return arises from a combination of manager decisions made about security selection, asset allocation, timing and execution, which cannot be replicated systematically.
Thus, the contribution of smart and hedge fund beta to asset management may not be restricted to the investable products themselves. It is possible that these indices will have a big role to play in making active managers more accountable for their performance.
THE FEE ISSUE IN A LOW-RETURN WORLD
Investing is a process fraught with uncertainty. Possibly the only area that the investor has certainty about is the cost, and particularly the indisputable fact that compounded costs over the long term significantly erode returns. The fee differential for a “typical” active equity fund versus a passive fund is around 65 bps in the United States and 130 bps in Europe (with average annual fees of around 70 bps versus 5 bps in the United States for active versus passive strategies and 160 bps versus 30 bps in Europe). Given that a performance of 50 bps over the benchmark is considered within the top quintile of performance, this fee is very high, as at current levels it 100 percent exceeds any incremental performance over the benchmark.
The same analysis for the hedge fund model paints an even bleaker picture of performance versus fees. Without the 20 percent-plus returns that marked the early years of the hedge fund industry from 1990 to 2000, it is increasingly unlikely that institutions, high-net-worth individuals and family offices will continue to be willing to pay the 2 percent management fee and 20 percent performance fee model (2/20). The competitive pressure from systematic indices is likely to bring down the fee structure for the majority of the industry, and not just closet indexers. When AUM pressure builds, active managers are also unlikely to let their businesses die, and they may react by cutting fees.
ACTIVE AND PASSIVE INDEX INVESTING
With the prospect of diminishing fees, it is probable that the growth of indexing will make several styles of active management less profitable while also favoring the growth of other segments. Styles that can be condensed into a well-defined and repeatable process with clear inputs and outputs will be the most vulnerable to automation. The styles of management that can best withstand fee erosion depend in some way on what can and cannot be “quantified” at a low cost — not all active approaches can be replicated in a systematic manner at low cost (at least not in the near future). An example of an unquantifiable strategy would be activist investing, where investors actively buy up large stakes in companies and then monitor and engage with them. Similar to activist hedge funds are private equity firms — a large component of their style is their influence over the direction of their portfolio companies. Like private equity, other specialist funds that focus on illiquid assets also will be relatively immune to erosion, given that these markets are harder to quantify. In contrast to public markets, in which investors have all the information, illiquid markets are difficult to replicate exactly, as securities cannot always be purchased quickly at a reasonable price.
Although they have quantitative beliefs in common, there is a considerable difference between a systematic index and active quant funds. While now there is virtually no reason to pay a manager 2/20 fees for the simple end of quantitative strategies, such as trend following using a moving average variant, the genuinely active quant space is a different realm altogether, in which the mandate is to harness the latest in quantitative techniques, research and technology to model complex interactions between liquidity, transaction costs, valuation and execution. Active quant funds are growing — in 2014, 52 percent of new hedge funds launched were systematic, 13 percent both systematic and discretionary and only 35 percent discretionary alone, according to data provider Preqin. Active quant funds can exist alongside smart and alternate beta, even with much higher fees, by competing on extreme sophistication in algorithms, big data, machine learning, and execution through significant investment in technology and talent. On the other hand, in order to stay low cost and, perhaps more importantly, transparent, indices always will be relatively more constrained and less refined in their algorithms, targeting the “bulk” of risk premia from anomalies.
The interesting question is: What will happen to traditional benchmarked active management? In order to preserve their business, over time these funds are likely to either lower fees or move toward either unconstrained multi-asset mandates or a more “High Conviction” approach, with the latter characterized by high active share, high tracking error, low turnover and concentrated portfolios. A high conviction approach would involve focusing on a handful of companies, understanding the financial statements in exhaustive detail, knowing the management and taking a strong point of view. What is noteworthy about a process involving such a level of specific detail is that it cannot easily be scaled and systematically applied to other securities in the market. Since these funds that focus on idiosyncratic sources of returns (returns outside of replicable beta) have much smaller capacity, the inference is that the size of the overall segment will be much smaller in the future.
The other way traditional active funds can retain fees is by moving toward unconstrained investing and adding other asset classes, derivatives, leverage and shorts to their mandate. Studies show that traditional benchmarked mandates are now under structural decline, with a shift toward unconstrained investing and alternatives that allow investors to use a more active set of investment techniques to target specific exposures. Thus, in the long term, there seem to be trends of both divergence and convergence at play in the active management industry. Divergence and clear positioning away from traditional broad beta mandates is already under way, but traditional active managers and alternatives will converge to some extent in unconstrained mandates or as suppliers of multi-asset solutions.
An interesting effect of not being constrained by a benchmark is that investment performance may improve, as managers are better able to develop a thorough understanding of portfolio companies and the risks that influence their long-term business values. In contrast to a high-conviction design, investing in a large number of companies and trading frequently may curtail long-term returns, as managers try to lock in short-term gains. Such wide-net approaches can also add to trading costs, further detracting from returns. Also, the more diversified and closer a manager is to the benchmark, the less likely it is that the manager will outperform, as it is difficult in the long run for closet indexers to overcome their own fees and beat the net return.
Thus, like many other industries, the rise of index investing is “hollowing out” the middle areas of the investment management industry. Active funds that will be most affected are those that operate in liquid markets and track beta or enhanced beta, as their value is virtually indistinguishable from the cheaper trackers.
“The future is like everything else, it is not what it was.” — Paul Valery
The story of systematic indexing has been powerful, though it is one of innovation in cost and replication rather than of innovation in investment theory. Investors have never been exposed to so much choice in low-cost passive products that target multiple risk factors and customized outcomes. A number of tailwinds will enable index-based investing to further change the fund management landscape, with significant implications for investors, financial advisers and active managers. The unbundling of returns through smart and alternate beta indices may help investors better understand return sources and allow more cost-effective targeting to both active and passive strategies. Active management is also likely to evolve in response, by targeting returns not easily replicable by systematic strategies. This shift in the landscape is inevitable and mirrors what has been seen in other industries with the advent of technological improvements.
Angana Jacob (email@example.com) is associate director, global research and development at S&P Dow Jones Indices.