August 23, 2017

The Active-Passive Debate in the Asset Management Industry

Ruben Calderon

Ruben Calderon
Executive Director and Advisor/VTFinTech UK PVT LTD

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The asset management industry is a vital pillar in the management of US household assets. A battle is raging for the dominance in that mandate between actively and passively managed funds, but it is predicated mostly on a cost advantage of passive funds while other worthwhile considerations are not getting much airtime but ought to be taken note of.

The importance of investment funds is borne by the evidence. According to the Investment Company Institute (ICI), investment companies account for 22% of US households’ assets at $19 Tn as of end of 2016 and constitute 55% of defined contribution plans.

Since its beginnings in the early 20th Century, the modern version of the mutual fund was, conceptually and in practice, an active fund made up of discretionary investment decisions. These decisions were a function of the fund manager’s degree of confidence in an asset’s expected profitability that would be, it was hoped, higher than the rest of the market as represented by a benchmark, say the market capitalization-weighted S&P500 index. However, over the past twenty years or so, the disillusionment with active funds has been rooted in their underperformance versus their benchmarks. The disappointment has been such that even actively managed US equity mutual funds that outperform their benchmarks have experienced significant outflows.

Even though actives still account for the lion’s share of total assets under management in the industry, total assets under management for passive domestic index equity mutual funds have risen every year since 2001 from 10% to 25% of total assets under management in the industry. From 2007 to the end of 2016 the passive strategies have taken in a cumulative net inflow of nearly $1400 Bn.. By contrast cumulative outflows from their actively managed counterparts for that same time period were -$1200 Bn. In 2016 alone outflows from active funds were in excess of over -$300 Bn while inflows into passives were over $250 bn. Thus far year this year the numbers indicate more of the same.

Passive strategies promise nothing but to keep pace with the market indices, which is why they are a less costly alternative and, understandably, the predominant consideration for investors. As active managers continue to fail to earn their keep, many observers have concluded that the demise of the actively managed fund is a foregone conclusion. In spite of the numbers, this is a dubious claim as there are some still unsettled issues as to whether the impossibility of active management in fact exists, or whether passives could become systemically important financial instruments.

It is worth remembering that the mutual fund industry is one of the most durable and stress-tested financial innovations of the last century. When the industry was in its infancy in the earlier part of the last century, the underpinnings of a solid regulatory framework came into existence and continue to define the playing field: The Securities Act of 1933, Securities and Exchange Act of 1934, the Investment Company Act of 1940, etc..

This regulatory ring-fencing made the active investment fund possible in the first place. Also, there are in fact actively managed funds with a respectable track record that is long enough to make one wonder whether the demise of active management is in fact a certainty. Investopedia lists eight mutual funds with an inception date before 1930 that are still active and each one with assets under management in excess of $1 Bn, and some of them well above that.

Active management, if not a re’ality, will always be a possibility. The talent pool and skill set that once enabled that industry to thrive is not an impossibility. The abundance of said talent seems to be in lower supply than the abundance of underperforming active funds would have us believe. The persistent underperformance of active funds of late should call into question whether the quality of their investments are commensurate to the quality of their investment processes and the degree of their convictions in said investments, not whether active management that earns its keep is at all possible.

There are emerging concerns, especially in the over the counter markets, stemming from passive investment instruments that ought to be taken under consideration

If present trends were to continue, we will eventually live in a world where a preponderant amount of assets will fall on the laps of passive strategies thus creating a highly uneven playing field. Financial market dynamics will be dominated by passives as well. By definition, passive funds alone will obscure, or even negate the existence of a price discovery mechanism for financial assets.

Consider a scenario such as a world where index funds manage the majority of assets under management in the mutual fund business instead of the 22% at present. By following the index and allocating funds accordingly, they would serve as a feedback loop into existing trends. Thus they could exacerbate a bull run upwards or a bear market downturn.

In addition, under such scenario, distortions over an undetermined length of time will deviate financial asset prices significantly from their fundamental underlying value. In the hypothetical case where over 50% of the stocks in the S&P 500 were to be dominated by momentum driven, high price-to-earnings stocks, That market could conceivably be dominated by publicly listed that have become very expensive (from expensive) and could represent poorly managed or, worse still, increasingly less profitable companies. So index funds in our scenario can make expensive companies would become forever, or for an as of yet undetermined amount of time, more expensive. This is the nightmare scenario for many managers: markets with good stocks but from bad companies.

In such an as-of-now surreal scenario the stock market would be deserving of being called a pyramid scheme.

Indisputably, passive instruments play a role in providing liquidity but it is hard to see how they can, by their very nature, act as a countervailing force in a world where highly-priced stocks and asset classes become even more highly priced.

Investors will do well to visit the “Education” tab in the Securities and Exchange Commission’s website to find out that there ought to be other considerations different from the cost advantage when looking to invest in passive investment funds. These considerations are being actively researched by academics and finance professionals, so the industry, and corresponding agencies, cannot be blamed of turning a blind eye to the issue. Some observers debate whether this is an exercise in over-regulation.The ubiquitousness of investment funds, and increasingly passive funds, as stewards of Americans’ assets and savings raise the need for continuing and better, not less, oversight.

Finally, actively managed investment funds serve a valuable socio-economic function in a capitalist economy and are powerful price arbitrageurs of financial assets. In a macroeconomic sense they allocate capital to where higher expected returns prevail and where there are unexploited investment opportunities. It is doubtful whether passive strategies alone can fulfill this role given their mandate, however praise worthy, to replicate an index and maintain a low cost appeal.

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