The Real Benefits of Active Management

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The Real Benefits of Active Management Key points: ›› There has been a seismic shift from active to passive management as investors seek to lower costs and increase returns ›› Active managers in aggregate cannot be expected to beat the market, but there is wide dispersion between winners and losers ›› Informed investors with technical expertise and skilful portfolio managers can beat the market through a forward-looking alpha source-based approach to exploiting market inefficiencies ›› That said, certain asset classes such as index-linked gilts may not lend themselves to active management ›› For those with cost constraints, a factor-based approach can offer a compelling alternative to traditional market capitalisation weighted indices ›› Passive investors need active managers to ensure efficient capital allocation in the economy and preserve investment returns

Inside: Active to passive—a seismic shift One of the biggest shifts we are seeing in the investment landscape today is the move from active management, where portfolio managers selectively pick securities with the aim of beating the market, to passive management, where the goal is simply to mirror or track the market. For some, the move is motivated by a desire to reduce fees; others have, regrettably, become disillusioned by the fact that many active managers have failed to beat their benchmarks in recent years. Flows from Active to Passive Funds in US Equities

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0 0 -200 Active maae -200 mta fs Billions of US Dollars -400 Billions of US Dollars -400 -600 -600 -800 -800 -1,000 -1,000 -1,200 -1,200 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Faced with the prospect of higher fees and lower returns, the benefits of moving away from active management do seem obvious—but is it that straightforward? The Real Benefits of Active Management

First, let’s remember that active management is a zero-sum game.

In aggregate, active managers will generate a return that is in line with the market less management fees. As these fees are higher than the costs of passive management, we should expect the average active manager to underperform the passive alternative net of fees. This simple fact is often forgotten—but expecting more of active managers en masse is misguided.

Rather than being the starting point that active managers must beat, the benchmark should be thought of as the outcome of the buying and selling decisions taken by all market participants, active and passive. And because the passive investors are just that, passive, it is the decisions of the active investors that actually shape the benchmark. Stocks that are out of favour come under selling pressure, fall in price and become a smaller part of the benchmark. Stocks in demand rise in price and become a larger part of the benchmark.

Clearly then, if active managers’ decisions are what define the benchmark, how can they, as a group, be expected to outperform that very same benchmark? For every Euro traded, there will be a buyer and a seller, but only one side of the trade will be right. For every winner there will be a loser and, in aggregate, the two sides have to net out to zero.

Chasing performance is no way to win

So, it is a zero-sum game, but there is considerable dispersion in active managers’ returns. Identifying, in advance, who will be the winners and who will be the losers is a difficult task though. It takes time, resources and expertise, which are just not available to most investors. Reports such as Morningstar’s annual ‘Mind the Gap’1 study or Dalbar’s ‘Quantitative Analysis of Investor Behaviour’2 have quantified the negative impact on mutual fund investor returns that result from poor fund selection. Buying past winners ‘high’ and selling them ‘low’ after periods of underperformance is the key failing. For many individual investors who do have technical expertise therefore, choosing a low- cost passive fund over a more expensive uncertain active manager is the rational choice. Even Warren Buffett, arguably the world’s most successful active investor, thinks so, famously instructing in his will that cash left to his widow should be invested in a low-cost passive fund. But what is right for Mrs Buffett is not necessarily the right decision for all investors, or perhaps even for society as a whole.

1 Mind the Gap: Global Investor Returns Show the Costs of Bad Timing Around the World. May 2017 2 Dalbar, ‘Quantitative Analysis of Investor Behaviour’, Report, 2017 The Real Benefits of Active Management

Hidden costs of passive

Investing passively may be cheaper than active, but that is not to say that there aren’t costs that might be overlooked by the unwary. One such cost is the opportunity cost of missing out on the superior returns that can be generated by skilful active managers for those who know where to look. Another is that, in the long run, poor capital allocation resulting from passive investment may undermine economic growth and, ultimately, investor returns.

Alpha sources and future success

There is considerable dispersion in active managers’ returns. It stands to reason that those investors who do indeed possess the time, resources and expertise to identify the winners in advance should do so—particularly if they also have the scale and thus the buying power, to push down fees to lower levels. Even a relatively small pickup in annualised returns will, through the wonder of compounding, boost long term returns materially. Identifying the winners in advance is difficult—relying on past performance is certainly no guide. Rather, investors must take a forward-looking view and allocate to managers and strategies that are built upon winning ‘alpha sources’ and result in portfolios with characteristics that are expected to outperform in the future. For example, higher quality stocks that are under-valued and enjoy positive share price momentum and improving earnings, should outperform over-valued, low quality stocks with poor momentum. Identifying such stocks sounds simple, but many investors fail to do so consistently (behavioural economics, a whole field of study, seeks to explain why). Portfolio managers able to exploit the resultant inefficiencies in the market can outperform over time (if not every calendar year), particularly if coupled with individual security selection skills and insights. The Real Benefits of Active Management

Factor-investing: Cost-effective alpha source exposure

One way in which these ‘alpha sources’ (if not the additional returns from stock-specific insights) can be captured systematically is through ‘factor investing.’ This segment of the active management industry has garnered considerable attention in recent years through both simple ‘smart beta’ products and more complex active quantitative strategies. Such products can provide investors a cost-effective means of obtaining exposure to factors— such as value, momentum or low volatility—that have been shown to be important drivers of share prices and offer the potential to generate outperformance. It is worth noting that, whilst factor investing has empirical evidence and academic research on its side (most famously by University of Chicago professors Eugene Fama and Kenneth French), strategies can vary significantly in how they are constructed and how they may perform, so investors must still be selective.

Efficient capital allocation

Whilst some investors who choose to invest passively are happy to forego the potential outperformance of active management for the certainty of tracking the market, many will not be aware of exactly how their capital is being allocated. The decision may be taken ‘passively’, but the decision will have an important impact on the investment outcome.

First, stock market indices can be very skewed towards certain sectors and be overly concentrated in a small number of stocks—witness the domination of the so-called FAANG technology stocks3 at the current time. Passive replication of indices can fail to deliver the levels of diversification that the typical ‘passive’ investor is presumably looking for. Second, passive investors make no attempt to allocate capital towards those companies that are actually expected to generate attractive returns on invested capital and shareholder value. Rather, they simply allocate on the basis of market capitalisation, investing an ever larger proportion in those companies whose value and share prices have already risen the most. In contrast, active managers are able to invest selectively—allocating capital according to the expected return on that capital. Indeed, a key role of active management is to facilitate efficient capital allocation within the economy at large. Companies that add value get access to capital, whilst those that don’t do not and will eventually fail. Similarly, if expected returns on capital fall, then share prices adjust; active managers thus provide a valuable service of ‘price discovery’ in the marketplace, promoting efficiency. Last, this process of capital allocation ensures that company management are held to account, thus improving corporate governance standards.

3 Mind the Gap: Global Investor Returns Show the Costs of Bad Timing Around the World. May 2017 The Real Benefits of Active Management

Passive investors need active managers

So, in a world without active management, capital allocation will be inefficient, companies generating poor returns on invested capital will be allowed to survive and, as a result, economic growth will fall. Lower economic growth will be reflected in lower stock market returns and thus lower returns for passive investors. Passive investors, therefore, need active managers to allocate capital efficiently on their behalf; without them the system breaks down. Even Jack Bogle, the father of passive investing, warns of ‘chaos, catastrophe’ if everyone indexed4.

4 Bloomberg.com, Bogle Says If Everybody Indexed, Markets Would Fail Under Chaos, 7 May 2017 The Real Benefits of Active Management

Final Thoughts

In the long run then, traditional market capitalisation-based passive investing cannot win. If it continues to take market share to the point that economic growth is undermined, then it may prove more harmful to investor returns than the relative underperformance of active management. The world needs active managers—just make sure you back one of the winners.

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