Insights & Commentary

Prime Services

The Next Generation of Active vs. Passive

May 9 2017

By Mark McGoldrick (reprinted with permission from EisnerAmper)

Passive investing has won the day; active management is dying a slow death as managers in this space have proven they can’t beat simple benchmarks.  Their alternative brethren, hedge funds, are really just fee structures and not differentiated investment products…  

This narrative has unfolded over the last several years and one needn’t look far to come across this viewpoint when reading about the active vs. passive story.  This well-worn debate is often framed by investment professionals in a binary fashion as to who is winning or losing based upon which camp they stand in.  But is this topic really a zero sum game or is it more nuanced and ever evolving like the market itself?

Passive management is certainly on an unparalleled streak with asset inflows surging to record levels since the financial crisis.  These massive inflows are due in part to an extended bull market in which investors are simply happy to keep pace with the indices and even happier to pay relatively little-to-no fees to do so.   Early this year the 2016 numbers were tallied and the continued praise of passive was quite predictable.  This year’s headlines and quotes from passive investment professionals have been unsparing and play out like the scene in Good Will Hunting where Matt Damon’s character (passive management) walks up to the window and from the outside looking in, taps on the glass and asks the other suitor, (active management), “Do you like apples?”  “Well I got hah numbah (inflows)…how’dya like them apples?”

Those inflows are certainly impressive and highlight how investors overwhelmingly voted their wallets in favor of passive.  According to Morningstar DirectSM January 2017 Asset Flow Commentary, passive management inflows into U.S. equity strategies made new record highs in December 2016. Some $50.8 billion of new assets poured into passive U.S. equity strategies, beating the previous monthly record of $41.9 billion set only one month prior.  By contrast, the report states that actively managed U.S. equity strategies slouched for a 33rd consecutive month with total outflows for 2016 reaching $340 billion. It is with good reason I might add.  The percentage of U.S. large-cap funds that have underperformed the S&P500 is glaring.  SPIVA Scorecard®, which has tracked active funds vs. the S&P500 for the last 15 years, reports over 88% of funds have underperformed and lagged the index in the last 5 years.  The number reached over 90% in a trailing 3-year period.

The fallout goes beyond the numbers with real life impact on the industry, which saw substantive layoffs of stock-picking units within traditional investment management firms.   Over the past year, Cowen Prime Services’ Business Consulting group has seen major investment talent from firms like Fidelity Investments, Putnam Investments, Boston Partners, and Loomis Sayles & Co. leave or be let go.  The most recent attention grabbing headline came in the form of BlackRock’s announcement that the firm is rethinking its active strategy.  So is active management in an irreversible decline?  I think it is important to put the “debate” in context.  Without delving into the importance of active management within the ecosystem of capital markets as it relates to price discovery and the formation of investible companies, we can assume active management isn’t actually dying.  Active management still dwarfs passive management in overall assets, and as many in the active camp would argue, passive management cannot exist without active management.  Some take that a step further and argue that passive gets a free ride on the backs of active management’s work, but that is a conversation for another time.

So where does all of this leave active managers today?  Clearly the trend is not their friend, but is there reason to be positive on stock picking?  Much has been written about how many policy and economic factors have created a rich environment for passive strategies to flourish in the post-financial crisis era.  Particularly, global central bank policies aimed at dampening asset volatility in conjunction with several factors including slow economic growth have caused a “bleeding up market;” surely, a difficult environment to exploit pricing inefficiencies for active managers.  As these economic and policy trends shift, good active management will be in a position to remind investors of their importance and ability to outperform.  Conversely investors should be mindful of this shift when you look at how passive (indexed) investing may catch investors off guard as indices often find themselves over weighted at the wrong times (e.g., financials pre-crash, energy, etc.).  However, economic and market tailwinds alone aren’t the panacea for what ails active management.

The active side of the industry has structural issues that need to be worked through.  Consider hedge funds for example. Their performance, fee structures and sheer number of players in the arena vying for assets is undergoing an evolution.  The ability to adapt and differentiate is the only way forward for new and emerging managers.  Starting with the latter, it is estimated that there are over 10,000 hedge funds world-wide.  However, it’s taken record closure rates not seen since the financial crisis just to get down to that number yet competition continues to be fierce.  As a result, the Ray Kinsella days of hedge funds have passed and old adage of “build it and they will come” isn’t likely to return.  Instead, differentiated, nimble, and thoughtful investment businesses must be constructed just to be given a chance to survive.

This competition has also had an impact on fees.  Clearly fund managers are hearing the message on fees loud and clear as new thoughtful fee structures are emerging.  Funds that include performance fees have to address the alignment of interest issue.  In the past, merely “having skin in the game” or “eating their own cooking” was enough to align with investors.  No longer.  Managers must realize that investors felt burned from past experiences where funds got paid for hitting it out of the park one year only to have a subsequent down year, thus leaving the investor holding the bill for less than stellar multi-year performance on a fee-adjusted basis.  As a result, many current fee structures incorporate management fees more in line (read a lot less than 2%) and performance fees with a hurdle or benchmark.  At Cowen Prime Services, we have seen certain kinds of strategies align their investment outlook with the fees they charge.  Essentially the fund’s performance fees are deferred or crystallize only after a multi-year period.  Moreover, new fund launches have recently gotten creative with “either/or” fee set ups.  In that scenario, managers get paid the greater of a management fee or the performance fee in any given year, not both.  Managers can expect to see this fee conversation evolve over time as the goal of alignment will vary depending on strategy and the individual allocator.

However, merely being cognizant of changing market forces and the ebb and flow of investor needs only get you part of the way towards running a viable investment business.  What will ultimately drive success is market outperformance.  Hedge funds that charge high fees for merely trying to beat an index are dead in the water.  The ones who are agile, can differentiate their investing and can adapt their businesses in today’s environment will be far better positioned to attract capital.  For example, a manager’s ability to synthesize information (like Big Data) more efficiently than their peers can be more impactful to their portfolios and performance.  Additionally, given today’s investment environment, having a broader understanding of risk management beyond just the position level is key.  That understanding will afford the agility necessary to navigate exogenous events that can create opportunity (e.g., Brexit, Trump, etc.).  Finally, forethought and preparedness beyond the portfolio will be necessary to tackle business threats like cybersecurity or the shifting tides of regulatory changes like MiFID2.  Managers need to fully appreciate not just the risk of not properly addressing these issues, but the opportunity cost it could have on raising institutional assets from investors keen on these issues.

Moreover, building a successful and multi-faceted investment firm also requires the right relationships, from employees and early-stage investors to the service providers they choose.  Service providers targeting active managers should be redefining what it means to be “a relationship business” and how to meaningfully contribute to a client’s success.  Jeff Solomon of Cowen & Company often discusses how the investment industry is improperly divided into buy side and sell side.  Instead, he believes what should matter is who cares about outperformance and active management and who does not.  Understanding how clients create alpha and dedicating the right resources to contribute to it will define the meaningfulness of those relationships. The next generation of active managers will need to rely on a network of partner businesses dedicated to active management to help foster their own.   Passive management is here to stay and the active vs. passive debate will continue ad infinitum.  However, as the investment environment continues to evolve, so too will the opportunities for active managers to deliver what they promise, alpha.