The Passive vs Active Investing Debate
Are we witnessing a resurgence in active management?
As the debate continues on the merits of investing passively or actively, our analysis indicates active management may be undergoing somewhat of a resurgence, admittedly having in aggregate disappointed investors over the last few years. Taking a broad range of equity sectors, it is clear from the chart below, 2017 was much improved in terms of the number of active funds outperforming their respective benchmarks when compared to 2016.
Source: Morningstar - data to 31st December 2018
Ah, but that is only because 2016 was such as poor year for active managers, I hear the proponents of the passive approach cry. Indeed, there is some truth to this, but even when we compare the percentage of funds outperforming in 2017 to the average of the last 5 years, as the chart below highlights, the statistics indicate a revival of fortunes for active management, which may mark a potential turning point.
Source: Morningstar - data to 31st December 2017
The question of course, is whether this nascent and noted improvement in outperformance is a counter trend rally in the long term decline of active manager’s ability to deliver outperformance or the beginning of a revival in fortunes for active managers?
We would argue the latter, for a number of reasons. Firstly, consider the chart below, which displays intra stock correlations for US equities. The trend has clearly been falling since 2016, and 2017 witnessed the lowest levels since the global financial crisis for US equity intra market stock correlations. This tends to be an environment which favours active stock pickers, and should provide a positive backdrop for active management.
Source: Datastream - data from 02.01.06 to 02.01.18
However, even in light of this improved stock picking environment, the growth of passive investing continues. Front and centre of this trend is cost, where passive investment has a clear advantage. We believe however, while cost is important, value is paramount and there remains a place for active management in the current investment environment. This must be justified through delivering a service, proposition and return profile which adds value.
Headwinds remain for active managers in order to deliver this value for clients. As the FT details*, ‘Vanguard has broken its own record as the world’s fastest-growing asset manager for a sixth successive year after raising more than $1bn in new fund flows every business day of 2017’, which was a 13.9 per cent increase on 2016. Combine this with the ETF business of Blackrock, iShares registering inflows of $246bn in 2017, a 76 per cent rise on the $140bn gathered in the previous year, and it is clear that the ‘wall of money’ invested passively is in itself a self-fulfilling unvirtuous circle. We have highlighted previously (If you have to ask, you can’t afford it) the dangers this approach entails and maintain risks are likely underappreciated by investors.
We would argue there are four key structural trends which investors should consider carefully should they wish to invest passively. These factors are early stage and may provide a tailwind for active management looking forward from here.
Firstly, have we witnessed the long term low in interest rates and if so, are we entering an environment of range bound or even rising rates? Clearly the long term bull market in fixed income has been a boon for passive fixed income investing, both government and corporate. Should this change, a passive approach to fixed income appears a more challenged concept.
Secondly, the rise of the East and emergence of China as a global economic leader has large ramifications for global equity indices, which remain structurally underexposed to Asia. Taking an active global approach will be paramount to capture this trend and an opportune environment for active management to add value.
Thirdly, it would appear the global economy is undergoing large scale technological disruption across a broad range of industries. Passive investing, by design, allocates the majority of capital to the largest companies, many of which are likely at risk of being targets of disruptive forces. Should disruption continue the environment may remain constructive for an active approach.
Finally and arguably most importantly, will the withdrawal of the extraordinary loose monetary policies which have characterised the post global financial crisis environment result in a return to a focus on individual company fundamentals? If so, active management is likely to surprise positively.
These structural trends and early signs of improvement in fortunes for active management provide an increasingly positive backdrop and we remain confident in the ability to add value from a genuinely active approach to investment management over time.
Head of Third Party Fund Selection
* Financial Times – ‘Vanguard retains title as world’s fastest growing asset manager’ 04.01.18
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