Passive strategies have seen strong inflows in recent years, at the expense of active managers. But David Lafferty, Chief Market Strategist at Natixis Global Asset Management, argues that in the long run the competitive pressures of passive indexing may save active management.
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 bleak, 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 in 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.
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. Regulatory changes also play a role. Directives like Retail Distribution Review in the UK and the new fiduciary rules in the US under the Department of Labor (DOL) Fiduciary Rule are forcing fund buyers to purchase lower-cost share classes with many of the extraneous costs 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 underway. A recent study by FUSE Research Network notes that average fees for active equity funds have fallen from 0.94 to 0.75 per cent over the past ten years – a 20 per cent 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.
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 with slimmer margins the days of sales boondoggles and giveaways are likely numbered.
Revenue pressures will force active managers to streamline and focus squarely on activities that produce alpha. They will increasingly turn to technology pioneered by passive managers to reduce labour costs and increase performance consistency. Smarting trading and more efficient use of quantitative techniques can lead to lower expenses and more competitive returns.
A greater focus on generating excess return will naturally drive managers to create more differentiated portfolios. As early as the 1980s, institutions began to recognise that portfolios could be made more efficient by separating cheap beta from more 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 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.
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 capitalisation (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 will 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 capitalise on it, the opportunities to generate alpha are likely to increase.
Finally, 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 and interest rates fell. 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 chance 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 realise 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 active strategies that can offer some downside protection that the indexes, by their very nature, can’t provide.
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 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.
David Lafferty is Chief Market Strategist at Natixis Global Asset Management.