Sailing in calm waters…?
Lake Wolfgang in Austria is as pristine a mountain lake as a von Trapp could conjure. Clear, warm summer water; mountains sprinkled with winter snow valiantly resisting the beating down sun; air purified by nature itself…
That is, until it isn’t. Hiding within this tranquil resides the capacity to catch the unaccustomed traveller short. Within a ten-minute spell, the darkest, most menacing of clouds can form; sirens awake to warn all those on the Lake to seek shore; rain lashes as hard as the wind howls and the bewildered family of four innocently caught in no-man’s land return drenched to the bone, but with a memory that will linger longer than the time it will take to dry out.
Investment markets have behaved in a similar fashion since the lows of March 2009, broadly behaving themselves, but being interspersed with sharp downward moves. Whether these sell-off’s were triggered by the US Debt Ceiling; European Debt Crises; slowdowns in China or most recently rising recessionary fears; the ten-year picture is one of equity markets unequivocally delivering for investors.
Rise of passives
This seemingly straightforward picture has assisted the rise of passive (or index) investing; if everything is going up then it’s an uncontroversial argument to buy that bandwagon at the lowest cost possible. Fund flows in to index trackers have been winning by a country mile against their active management cousins. According to Morningstar, for the year ending May 2019, passive (or index) funds received net inflows of $460 bn, compared to net outflows in actively managed funds totalling $340 bn and at a sector level net flows were almost universally better for passive than active.
With this shifting dynamic within the market, what we need to try and understand though are some of the implications this large block of ‘passive’ capital may have on the market place, the consequences of this and how best to adapt to it.
Standing in front of a train/ Have active managers become too small to make a difference?
The displacement of active managers in favour of passive (or index) funds have led to our having a discussion recently with one of the fund managers we own, whether there are enough people like him who share a different view to the market’s current direction of travel (large cap, quality growth with overseas earnings) to make any difference in extracting the value he sees. The large blocks of passive funds flowing indiscriminately in to the same companies, ignoring the ‘value’ he sees in companies that don’t fit with the current market momentum.
As an individual, whilst the low-cost passive choice will seem a perfectly sensible and rational choice, at a collective level do all those trades which ultimately go to buy shares in the same companies without any sense check on that company’s quality or ability to question whether the price represents good value, ultimately lead to poorer long-term returns due to a deteriorating quality of the workings in that overall marketplace?
Despite the headlines about the death of active investing and the rise of passives, according to a 2017 study, even in the US equity market which has been at the forefront of passive investing, it still ‘only’ represents $4 trillion (or 43%) of US equity fund assets which, in turn, represents 15% of the total US equity market. Significant, yes, but not all encompassing.
There were claims made by Michael Burry that there was a “bubble” in passive investing; the argument being the rise of passive investing has directed too many assets in to too few (predominantly large) companies, leading to company shares being incorrectly priced – the beneficiaries priced too high, the overlooked undervalued.
I don’t think there is much controversy in saying daily share price movements are being set by an ever-rising number of trades being made without any fundamental assessment of long-term value. Whether that is through the increased use of passive funds is debatable or, more likely, by algorithmic trading strategies focused on the very short-term price movements. Ultimately, however, long-term share prices will continue to be driven by some form of fundamental analysis, with the active manager best served to benefit from inefficiencies that arise and serve as a natural restraining force against the perpetual rise of passive. The eventual balance between active and passive strategies will also be determined by the underlying efficiency of the market being tracked with less liquid, less researched areas seeing a higher propensity of active managers than passive.
What we’ll most likely see evolve is continued flows out of more expensive closet-tracker active funds in to low cost index tracking funds and a more defined active management industry, where those that thrive will be more active, more differentiated than witnessed in decades past. There is some evidence to suggest that where a particular market has a large passive investor base, the healthier the active investor market place is too. Driven by increased competition the active manager not only becomes more ‘active’ and more differentiated but is also prepared to do this for a lower fee.
Dare I say it, Reputational Risk
Neil Woodford’s liquidity crisis and fund suspension; similar illiquidity issues and internal breaches in GAM’s $8.5 bn bond fund during 2018; a poor Chinese adventure from Fidelity’s star manager, Anthony Bolton earlier in the decade have all served to chip away at the reputation of the active management industry. In many cases, rightly so.
There is also a broader pressure facing investment decision makers whether it be Pension Trustees, Corporate Investors or Personal Investors and that is in the reputational risk of ‘going active’. See the negative headlines about the Kent Pension Fund when it sought to withdraw capital from Woodford; a limited example maybe, but a situation that will result in a ripple-effect of decision makers avoiding the quest for outperformance for the sanctuary of the passive option and the guarantee of lower fees.
For firms like us who operate Buy Lists of funds, as a consequence of consolidation within our industry, there are increasingly few decision makers who typically operate relatively concentrated Buy Lists, focusing larger amounts of capital in to fewer and fewer funds. With lower returns expected and therefore active fees becoming a higher proportion of overall returns, the share of passive funds are on the rise in the sector too. A survey by Citywire says, amongst UK adviser firms, whilst there remains a clear preference for active funds in portfolios (about 2/3rd active, 1/3rd passive), the share of passive was on the rise.
As with many of the arguments around passive and active investment strategies there remains no clear right or wrong. There seems little foundation to argue that the rise in passive investing is creating ‘bubble’ like conditions, but there is great sway in saying it is changing the way portfolio constructors and asset managers build portfolios.
Our sense is there will be a continued trend for rising numbers of assets moving away from benchmark constrained (closet index), actively managed funds in to low-cost index-trackers. The corollary to this will be a higher quality, but smaller, active-management industry which will ultimately serve as a better champion to its end investors. Surely, that’s a good thing.