Last week, two articles published on Citywire revived the passive-versus-active debate, which all too often misses the point.
The first piece – “A better year for active managers” – was a review of the latest South African SPIVA (S&P Index vs Active) report. It showed that most actively managed funds underperformed the market over the past year, even though far more active funds beat the index than in previous years. As the article correctly pointed out, the overwhelming majority of managers fail to beat the market over the long term.
The second, rather emotive piece, penned by Simon Evan-Cook, bemoaned “the passive zealots” and denounced the ‘zero-sum game’ theory supported by the likes of William Sharpe.
Believe it or not, “passive zealots” frustrate many passive asset managers too. This is because advisors and clients don’t want an argument – they want solutions that help them navigate the complex, jargon-heavy world of investing. It doesn’t help the savings and investment industry to position the active-versus-passive debate in such a binary fashion. While Simon acknowledges this, his argument was, well, binary.
The exclusively pro-active argument ignores the fact that picking winning managers in advance is extremely difficult (retrospective selection is obvious), and the benefits of lower costs over time – a structural advantage of passive investing and a differentiator between active managers too. Furthermore, it also does not consider the heightened importance of liability-driven investing, matching investor goals with asset allocations (rather than obsessing over stock picking and trying to time the market).
Of course, the dynamism and complexity of capital markets presents opportunities – and risks – for investors and actively managed funds. At the end of the day, capital markets do require active participants for them to function optimally.
Since this should not be an either/or debate, here are some ideas, mostly borrowed, on how the investment industry can evolve and how different players can refine their respective value propositions.
Active managers need to be sufficiently resourced but also humble and realistic about the value they can add.
Large-scale “super-tanker funds” – which are not able to make sizeable active bets – deserve all the criticism coming their way as they contend with regulatory scrutiny in certain markets. Investors should not be paying active fees on the whole portfolio when only a small portion is being actively managed, and the bulk is simply tracking the benchmark.
The managers that will succeed into the future will be truly active, with a significant portion of their portfolios being actively managed – or different to the index. Over the long term, they will likely have a reduced market share, but could maintain their margins as they invest in research and set themselves apart. In making this argument, I often reference this opinion piece by Eric Balchunas.
Aside from stock selection, there are many other important differentiators, including how investment firms (both active and passive) respond to climate change, their approach to stewardship, and how they integrate environmental, social, and corporate governance (ESG) factors.
Finally, there are a number of asset classes that are still dominated by active managers, including fixed income, private markets, and alternatives.
Multi-managers and solution builders:
Multi-managers and discretionary fund managers are well placed to blend active and passive funds. Regrettably, many of these firms continue to focus on finding the next star manager, or on picking multiple active managers, in the search for outperformance. We have calculated, based on the current SPIVA report that the probability of picking three active managers who all outperform the market (as represented by S&P SA Top50) over a five-year period is less than 1%. It seems implausible that multi-managers, despite what the statistics show, continue to have no allocations towards passive funds.
As mentioned, the investment industry is increasingly moving towards outcomes-based frameworks, with less emphasis on achieving alpha or super profits. It is an approach that lends itself once more to a higher allocation towards passive.
In this new paradigm, the winners will be those who blend the two approaches to satisfy the needs of the client.
The role of the financial advisor has changed dramatically in recent years due to the proliferation of investment products and downward pressure on fees.
In this new landscape, financial advisors are increasingly incorporating low-cost passive investment products as they seek to minimise overall fees and deliver on the long-term goals of the client.
The passive component reduces fees, improves diversification, and enhances the predictability of returns. Importantly by providing sound advice and keeping their clients invested through the cycle, clients remain aligned to their long-term financial goals. To achieve those outcomes, advisors have a critical role to play in encouraging investors to ‘stay the course’ – to remain invested – and to avoid making impulsive decisions when market conditions change. The concept of Gamma – “the value of advice”, as coined by Morningstar – does not include the pursuit of alpha.
With this in mind, we believe the active-versus-passive debate should be put to bed – both approaches have important roles to play in the modern investment landscape.
To learn more about how IFAs, DFM and Fund buyers blend passive allocations into portfolios, view our educational webinar series: Your Passport to Passive.