August 23, 2017
The Active-Passive Debate in the Asset Management Industry
Share This Post
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
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
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
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
Active management, if not a
There are emerging concerns, especially in the over the counter markets, stemming from passive investment instruments that ought to be taken
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
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
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
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
Share This Post