Over the course of several years, investment flows have continued to shift from active fund managers to passive vehicles. More than $3.5 trillion had moved into exchange-traded funds over the past 10 years as of October, according to the Financial Times, while funds in US index-based equity mutual funds and ETFs overtook assets in active funds for the first time in August.
There are several reasons for the ongoing rise of investment flows into passive funds. The most obvious is that far too many so-called active funds don't do enough to diversify their performance from underlying indexes, while charging far higher fees than index funds. This isn't always their fault; US blue-chip stocks are extremely information-efficient, which makes it difficult to outperform. In addition, for most of the past decade the US market has generally trended upwards in a smooth manner, making it hard for active funds to outperform – particularly net of fees.
However, that still means institutional and retail investors in the US and Europe realise there is little benefit to investing into such active funds. That's encouraged them to increasingly shift to index funds or a variation thereof, while some have looked to funds formed using different factors, be it value or momentum or even environmental, social and governance (ESG) principles.
Japan's Government Pension Investment Fund, which has about 85% of its assets in passive funds, is one example. Another is the California Public Employees' Retirement System, the largest US pension scheme, which in October fired most of its external active equity managers due to long-term underperformance and invested nearly $14 billion into internally run index funds. Moreover, the Alaska Retirement Management Board, made a similar move this year.
However, a great deal of uncertainty surrounds the markets for 2020. That gives some market experts hope that astute active investment funds could demonstrate their worth. Plus fund managers point to the fact that some parts of the equity market are inefficient, offering more opportunity to outperform indexes that represent them.
We asked four investors and market experts to offer their opinions on the potential appeal of active versus passive investing into 2020.
These contributions have been edited for brevity and clarity.
Vincent Mortier, group deputy chief investment officer
The first decision for institutional investors in particular is not active or passive, but how they want to allocate between asset classes and geographies.
Passive investing requires choosing the indexes you want. They are not all the same, and you need to be aware of the differences and biases you embark on with particular indexes. Plus you need to decide what weightings you want, how your allocation is managed, and choose between the many variances and different factors available.
Conversely, with active management you have a better understanding of the fund manager's strategy of engagement with companies, and the style you want them to deploy [in a segregated mandate].
Over the long term I believe the two are complementary. Some asset owners use passive [investments] to implement part of their portfolios in a cheaper manner, and they need to decide if they want to make [broad investment] choices on certain allocations or whether they want more intelligence and inferences.
Some markets are harder to invest in on an active basis like US equities, while others are less efficient. I would say active management works better in emerging markets, as well as small end medium-sized companies and some sector-specific investments. An ESG approach would also be well adapted to active management, as you can make a difference through engagement if you want.
Deborah Fuhr, managing partner
Index investing and index ETFs will continue to gain popularity in 2020 as investors learn that most active funds in most countries continue to underperform their benchmarks on a one-, three- and five-year basis.
The reason for underperformance is often due to the high fees charged by active funds. The most recent SPIVA report indicated that over the one-year period ending June 2019, 85% of large-cap equity funds and 88% of mid- and small-cap equity funds in Canada underperformed the benchmark. Similar results are found in other countries.
Using index investing does not mean that investors are not searching for ways to generate alpha. Many professional investors, financial advisors and some retail investors are using index products as tools to generate alpha through asset allocation. The growth in multi-asset funds and model portfolios which use index ETFs will be another driver of growth in 2020.
Robo advisers and fintech solutions will be another driver of growth for index ETFs in 2020. Robos are aiding in financial education of investors and specifically in index ETFs as the building blocks for the majority of robos.
Jean-Louis Nakamura, chief investment officer for Asia Pacific
The move from active to passive started almost 20 years ago and is nowhere close to reversing. It is the result of strong structural forces in favour of lower fees, more transparency, more predictable outcomes and a continuously shrinking space for “true alpha”, especially with the rapid development of smart beta solutions. We don’t see any reason why those forces would disappear in the near future.
Of course, some sub-universes such as emerging equities or debt, still less efficient on average, may offer greater room for active managers, at least for some time. However, the most promising field for true active high-conviction managers over the next few years seems to be the sustainable/ESG space.
Why? Because precisely, while not a new concept, sustainability/ESG still appears as a new factor – whose independent return stream from other factors (quality, growth, value, etcetera) has not been clearly established yet and that quant/passive managers still struggle to model convincingly. Therefore indexes are still slow to incorporate this dimension and investors are even slower to adopt 'sustainable indexes'.
Active managers convinced that true sustainable companies will outperform – due to tighter regulations increasingly penalising negative externalities – could generate substantial active returns if their conviction prove right.
Simon Coxeter, director of strategic research
Active managers faced headwinds over the last decade, including low cross-sectional volatility, strong performance of passive traditional exposures and concentrated outperformance in technology/growth stocks.
Quantitative easing suppressed volatility, but stability can breed instability. With a long market rally behind us – and geopolitical, economic and longer-term structural uncertainties ahead of us – active strategies are powerful tools in positioning portfolios to navigate through and capitalise on the future.
Passive exposures can play a constructive role, particularly for fee-/governance-constrained investors, and in efficient areas like US large cap equities. Investors will continue to reallocate fee budgets away from active listed strategies towards higher-fee alternatives exposure.
Our experience demonstrates that manager selection can identify value-adding active strategies across many market segments. A range of active strategies help position portfolios for this environment, including hedge funds, multi-asset strategies, equity strategies with higher active shares and/or specialised in less efficient areas like small-caps/emerging markets, and strategies focused on active ownership, real assets and sustainability. Value and emerging markets, which have lagged broader indices, may bounce back.
Crucially, achieving good outcomes from active management requires more than manager skill. Investors must be wary of behavioural biases in hiring and firing managers, and fees must be appropriate.