This post is the second part of the column I started 3 weeks ago. Having outlined the challenges that independent financial advisors were facing with regards to the fund allocation process, I will now turn to the actual investment process. In this area, a raging debate has been taking place for years between two philosophies, namely active and passive investing.
Definitions are straightforward. Active investing consists in actively managing a portfolio of securities (e.g. stocks) in order to permanently allocate funds to the most undervalued ones. Success of that strategy can be monitored by assessing the relative performance of the active fund against the benchmark index (e.g. the S&P 500 or the FTSE100 for US and UK equities respectively). Conversely, passive investing assumes that beating the market consistently over time is impossible and that tracking the market evolution at the lowest cost actually represents an optimal investment strategy. To do so, passive investors will rely on Exchange Traded Funds (ETFs), whose sole objective is to track “an index, a commodity, bonds, or a basket of assets like an index fund”.
In this video, Fidelity’s Julien Timmer presents the pros and the cons of the active and passive investment strategies. By reaching the end of this post you will have understood why active investment is presented under a slightly more favourable light.
The myth of successful active investing and the ‘search for alpha’ – in investing jargon, the ‘alpha’ represents positive returns achieved irrespective of market conditions – has been kept going by the asset management industry lobby itself, whose existence relies on the volume of funds dedicated to active investing. A number of magazines and newsletters – such as ‘Investir’ in France – praises the upside potential embedded in the stock markets and share investment tips with their readers – with a different angle depending on the market conditions. More recently, scholars have shown that the rise of social networks has enabled individual investors to share their successes more easily and has therefore increased the level of active trading – dubbed as ‘Facebook Finance‘.
Although the debate is relatively balanced at a retail level, institutional investors have been implementing a significant shift in their investment policies over the last 12 to 18 months, showing a soaring appetite for passive (and cheap) funds. Morningstar estimated that $245bn flowed out of active funds between February 2015 and January 2016 while $408bn flowed into passive funds over the same period. And it appears that the tap is not closed yet: a Greenwich Associates survey reported that nearly 20% of non-ETF users were considering to add them to their portfolios this year.
The hype for ETFs can be dated back to 2013, when Warren Buffett outlined in his annual letter to Berkshire Hathaway’s shareholders the investment strategy he would like his trustee to follow after his death:
My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.
As made explicit by Buffett, relative cost of active investment is the key driver behind this change, especially in a low-growth and low-inflation market. As active management requires by definition the close involvement of dedicated professionals, those funds charge a higher management fee (up to 2% p.a.) compared with passive funds (which can go as low as 0.15% p.a.). Investors do not really bother when annual growth is reaching 4% and inflation contributes to alleviate management fees in real terms – this was the situation a decade ago. Today, a marginal difference in fund cost structure can have a significant impact on the net return for the investor, especially given that scholars have proven that almost no active fund can overperform – net of fees – its benchmark index over a prolonged period of time. In tough times, any saving counts, and investors are not willing to pay more for meager returns any more.
No surprise then that the lavish lifestyle adopted by some asset managers has been critiqued over the last few months, not only by the general public but by the regulator as well. On top of that, the FCA found that several funds were misleadingly marketing themselves as ‘active funds’ (and charging high fees to do so) while they were using a benchmark-related approach.
The massive inflow generated by ETFs has pulled a series of new entrants which are now competing with the three historical incumbents – namely BlackRock, Vanguard and State Street Global Advisors. The Financial Times reported more than 3,882 tracking funds as of end 2015. This increased degree of competition has led ETF managers to further lower the price of their funds and to offer a wider range of products, making the ‘passive’ proposition even more compelling. This does not go without risk though: the increasing amount of capital gathered by ETFs may add violence to market movements.
Bond ETFs are also finding their way to the market but their relative lack of liquidity makes it a more expensive and riskier investment alternative for the time being. As a consequence, the bond ETF market only grew by $42bn in 2015, equivalent to a tenth of the inflow recorded on stock ETFs.
So is there a future for active investing? Definitely. To survive, active investors need to restore their price competitiveness. This is non-negotiable and actually some funds have recently started to take this path, cutting their fees by up to a third. From there, I personally see two non-mutually exclusive options. One is for active managers to look after securities that indexes do not cover (yet?), and have enough conviction to stick to them, even in difficult times – although in the long-term this path could be threatened by the rise of artificial intelligence which will significantly lower the cost of extensive securities coverage. Separately, active investors should also seek to add value not only in their investment decisions, but in the post-acquisition phase as well. This is the model that some alternative asset providers, such as activist hedge funds and private equity vehicles, have been following for decades by trying to get their voice heard at Board level. In any case, the status quo will rapidly cease to represent a viable option.
Last but not least, Sensible Investing, an organisation promoting passive investing, released a (very subjective) documentary highlighting the shortcomings of active investing. This is a good summary of the points exposed above if you have almost an hour to spare (!).