WEALTH INSIGHT
An argument for active investing
There are both structural and cyclical reasons to shift from passive investing.
THE move from active to passive investing has been nothing less than seismic for the asset management industry. In the past 10 years, passive equity has gone from around a tenth of total equity assets to over a quarter, and the momentum in this growth seems inexorable.
We believe there are many good reasons to invest in passively managed funds. But while we find the reasons for the shift compelling, we offer three thoughts as to why we think this might not be the time to accelerate the move.
- Fund Alpha is more important later in a market cycle
If you'd had perfect foresight in March 2009 with the S&P at a low of 667, you would have gone 100 per cent long an equity ETF (exchange-traded fund) and be done with it - and you would have been absolutely right.
Assume you found a great long only manager who, you were pretty sure (but not certain), could beat the S&P by 300bps a year. You could just buy your ETF and compound returns at 20 per cent annually for six years, or you could buy the great long only manager and compound at (possibly) 23 per cent for six years.
The market's contribution to your return is 20 per cent out of 23 per cent - that's 87 per cent beta and only 13 per cent alpha, and the manager may not perform. There would be no reason to bother with active equity when the equity beta offers such bounty.
But now, after the S&P has trebled in price, most people would say that the risk premium is somewhere between 2 and 4 per cent. Add in the bond yield of 2 per cent and your expected total return to US equity is in the range of 4-6 per cent per year.
The picture is now rather different. Your active manager is still, you hope, going to deliver her 3 per cent expected alpha on top, making your expected return 7-9 per cent. This means she could now deliver a third to nearly half of your expected return.
Furthermore, if the beta available from passive equity is only 4-6 per cent, this poses a major problem for institutional investors, whose return targets are very often above that. The picture has changed, and active may be starting to be worth the risk.
- The stock-picker's opportunity set is increasing structurally
We think that these moves in the alpha opportunity set are explained by sensitivity to macro events. When leverage is high, banks are undercapitalised, ROE is low and the monetary transmission mechanism is broken.
Markets are clearly highly sensitive to macro events, notably the actions of central banks and other authorities.
For example, from 2008 to 2012, what seemed to matter for the stock performance of Italian banks wasn't whether they were a good Italian bank or a bad one - it's that they were Italian banks! If macro improved, the stocks rallied; if it deteriorated (and it generally did), the stock fell.
Since 2012, however, we observe that there is more dispersion between like stocks. See, for example, the outperformance of Intesa and Mediobanca since European Common Bank president Mario Draghi's "whatever it takes" speech versus the halving of Banca Monte de Paschi di Siena and the rather tepid returns to shareholders of Banca Popolare and Unicredit. We believe Alpha is returning.
- Smart beta may not be so smart
Our final pushback against a wholesale move into passive equity is that we expect that the more assets that are passively managed, the more opportunities for active managers to focus on the individual factors that can drive stock performance.
The same criticisms that apply to simple market cap weighted indices (they are price momentum-biased and take no account of valuation) may equally be levelled at a lot of other smart beta strategies. Take minimum volatility strategies, for example.
Launched with great fanfare in May 2008 by MSCI (the first in the market), with compelling risk-reward characteristics, these have just about kept up with the total return benchmark over time, but have also had long stretches of underperformance. If it was an active manager, we believe you would fire it.
The final problem we see here is that, if you choose smart beta instead of pure index ETFs, taking money away from active managers still requires an active decision. That's because someone still needs to time the factors - for example, from value to growth and vice versa, as the market cycle demands. Who is going to do that?
In summary, we contend that the balance between active and passive management is shifting in favour of active management.
We believe there are both structural and cyclical reasons to look again at active managers, for whom the opportunity set is increasing as the global financial crisis recedes in the collective memory.
The structural reasons are the return of dispersion and the opportunities thrown up by smart beta. The cyclical reason is that late in a market cycle, the risk reward of active management improves, assuming that alpha is constant while beta is lower. And now having set ourselves the task, it is up to us to prove these assertions.
- The writer is portfolio manager at Man GLG
