November 22, 2019
Fundamental analysis tends to be the bedrock upon which most professional investors build their investment strategy. While fundamentals are indeed a good foundation to begin with, there are other factors which play a part in influencing the directionality of markets – of course these are human elements, psychology, preferences and cognitive biases that can manifest in markets, but which are difficult to quantify.
How and why people invest the way they do affects prices, and at times can even overshadow fundamentals (at least in the short-term). In this focus piece, we looked at one of the important trends in asset management – that is the seismic shift in investor preference from active to passive management over the past decade. We interview our Head of Funds, Lionel De Broux to ascertain his view on this trend and whether one style is better than the other. As the battle between active and passive rages on, we conclude that a less polarised view is optimal, believing that neither investment style should be used in isolation.
Passive investing can involve both index funds and exchange-traded funds (ETFs), can you describe the difference between these two?
A common passive approach is to buy an index fund that follows one of the major indices, like the S&P 500 or the Dow Jones. Passive strategies track the returns of an index and are typically implemented by holding each of the indices’ constituent securities in line with their weight in the index. Whenever these indices re-balance their constituents, the index funds that follow them sell the stock that’s leaving and buy the stock that has been adopted into the index – passive strategies require no trading in the absence of changes to the index composition. Index funds are ‘open-ended’ in that investors subscribe directly into the fund or redeem from it. This is normally done once a day, using the NAV (net asset value) price. The first index fund was pioneered by John ‘Jack’ Bogle in 1976 and still exists today under the name ‘Vanguard 500 Index Fund’.
In 1993, the first Exchange Traded Fund (ETF) was created by Nathan Most – State Street’s S&P 500 Depositary Receipts fund (also known as SPDR, pronounced ‘spider’) which has grown to be the largest ETF today. ETFs, which can track an index, a commodity, bonds or a basket of assets, resemble a standard mutual fund in that they have almost identical structures. However, the ETF was revolutionary as investors do not have to buy into or sell out of the fund using the NAV price, rather, shares in the fund can be traded on an exchange all day long in real time and managers can create or redeem shares in line with demand.
Index funds and ETFs contrast with actively managed funds, which seek to earn higher returns than their chosen benchmark through discretionary security selection and composition or trading in anticipation of market turning points.
When looking at assets under management on passive and active funds, what are the main trends ?
To start with, it is important to make the distinction between instrument growth and asset growth. While the number of new instruments skewed towards passives, assets are still predominantly managed through active funds. According to Morningstar data, worldwide index funds represented 17% of total fund assets. The observed growth trend for passive has been quiet impressive but it’s relevant to “kill a legend”: active is still far ahead.
The growing popularity of passive strategies is especially visible inside US and Japanese equity funds. For the US large capitalisation equity market, a remarkable milestone was established some weeks ago with the total assets in index-tracking funds surpassing the amount invested in active stock-picker funds. In essence, active US large-cap equity funds faced net redemptions while passive have seen inflows for the last 10 years (on a yearly basis).
While passive funds have caught up with their active equivalents among US equity funds, active funds continue to hold market share in other asset classes where information is more scarce and markets are less efficient. Furthermore, while passive funds have made substantial inroads into the universe of investment vehicles available to end investors, their holdings as a share of total outstanding securities remain at a relatively low level due to the sizeable holdings of other (non-fund) investors. According to a 2018 BIS calculation, the share of securities held by passive fund portfolios is highest for the US equity market, but it still amounts to only around 15% of the total. Shares of passive funds in other equity markets are lower, at about 5% or less.
Today, in Europe, within passive strategies, the split between ETFs and index funds is about 50/50.
Ascertaining the true extent of passive investing could be challenging. Sometimes, in practice the distinction between passive and active fund strategies is fuzzy. The risk of outflows if they underperform their benchmark leads many active funds to avoid portfolios that deviate substantially from those of the market index.
And what about smart beta?
So-called ‘Smart beta’ funds are a halfway house between active and passive investing. Whilst these also track an index, they use human experience, judgement, engineering, and creativity to apply alternative construction rules, unlike traditional ETFs which typically weight the assets they hold based on market capitalizations of the index they track. Additional ‘screens’ or ‘rules’ hone in on fundamental factors; for example, a smart beta strategy may be dividend oriented, thus algorithms and computer-based rules will further screen the index for assets with dividend growth which will be given a higher weighting. In this way, they can attempt to exploit any discrepancy in assets overlooked by traditional passive market capitalization approaches.
This is perhaps more effective in the bond space because, investing in bonds based on market capitalization, in essence means that you will be more exposed to the countries/ companies which issue the most (i.e. those that are the most indebted).
In essence, the rise of “smart beta” ETFs further blurs the distinction between passive and active fund management. Rather than tracking traditional market value-weighted indices, smart beta ETFs implement factor-weighting index strategies, the construction of which can be considered active in nature.
What are the downsides to smart beta strategies?
Smart beta is just like high frequency trading – at first, when this became trendy, there were only a few players and you could make money on it. But the alpha shrinks as more players enter the market. Now, to be competitive in high frequency trading, you have to invest substantially in tech and in talented people. It is very expensive. The same will happen for factor based investing. Each new player reduces the slice of the cake for the other.
Broadly speaking we observed some kind of self-reinforcing forces at play. The bulk of money flowing into passive funds over recent years has been directed to the largest fund managers, which tend to offer the lowest-cost funds. Since 2010, the three largest passive fund managers have received around 70% of cumulative inflows. This pattern of inflows can set in motion scale economies that help compress fees. Greater fund size mechanically reduces fund expense ratios and allows managers to further invest in cost reduction and new products, in turn helping them to attract more inflows. It also enables greater netting of inflows and outflows, as well as the negotiation of more favourable trading fees from brokers, thus reducing trading costs.
Investor appetite for ETFs has been growing, do you think ETFs will continue to grow at a faster pace than the overall fund industry?
Drivers of passive growth have been multiple. Some argue that the shift inside the financial industry (e.g. the rise of so-called “robo-advisors”, a move away from commission-based remuneration and increased scrutiny on fee transparency) were at play. We believe that for European investors, regulations embodied within the second Markets in Financial Instruments Directive (MiFID II) impacted the distribution model of passive vs. active funds. As such, any new distribution model could further alter the landscape.
There is also the fact that we are now in a late cycle environment. Essentially until now, markets have been on an upward trend, and ETFs offered a way to ride this trend upwards. Obviously investors don’t want to ride this same wave when things start to crest downwards, and so will start looking for smarter ways to invest, probably turning back to more active strategies. Active managers tend to earn their stripes when volatility stirs and cross-asset correlations come down.
What makes passive strategies attractive to investors?
From a theoretical perspective, the rationale for individual investors adopting a passive investment strategy is grounded in the notion of efficient markets. If you believe in efficient markets, security prices are supposed to incorporate all available information. This implies that excess future returns are not predictable and that there is limited room, if any at all, to generate returns above those of the market. So why pay someone to do so? In reality, markets aren’t fully efficient, all of the time.
Some retail investors hold a misconception that ETFs can even come free of charge. It is not the case – perhaps the cost won’t be explicit, perhaps it will be passed on through the bid/offer spread, but there will be some kind of charge.
Why are active strategies still relevant?
We are convinced that there are still strong cases for active management.
First, informed active managers can earn above-market returns to the extent that the investor universe also includes active but uninformed investors whose aggregate portfolio underperforms the market. Second, passive fund managers must trade to manage investor inflows and outflows. This means that, potentially, informed active investors could outperform the benchmark by taking advantage of passive managers’ predictable patterns.
It is crucial to understand that using an active strategy implies that the objective of implementing trades in anticipation of market turning points, gauging when relevant to adjust portfolio in front of structural and tactical drivers.
Looking at highly liquid, more efficient markets such as that for US large cap stocks, it is more difficult to beat the market. Only 25% of active products outperform. In this instance, and in the appropriate phase of the cycle, passive products with lower fees may be more appealing.
However, we caution against saying that the majority of active funds underperform as headlines suggest. To accurately compare, you would need to create a basket of similar strategies, rather than comparing their performance to the entire universe which is what many of the naysayers fail to do.
Is there a dark side to ETFs?
Well yes, because over the long-term (10-15 years) you see that active strategies perform better on a large portion of the investment universe. Whether the industry has the patience to wait for active managers to generate alpha is another question. Small caps, for example, outperform large caps. Passives on the whole, predominantly offer exposure to large-cap blue chips, because they have to be efficient in the selection process in order to have low fees. Therefore, you are missing out on potential alpha.
There also can be hidden complexities that aren’t fully understood by retail investors who perceive passive strategies as less risky. These are often applied in order to reduce passive fees (to stay competitive).
Just one example of this is synthetic replication. Here, the passive manager uses swaps to recreate the index. If the counterparty goes bust, then the end investor ends up exposed to something that was not on the label – not exactly what it says on the tin!
Some others have been known to lend out the underlying securities in order to make additional earnings. However, after this blew up in 2009, during a liquidity crunch and the market dried up resulting in material losses, this strategy is much less utilized today.
Are ETF flash crashes a risk?
Not really, because investors will immediately see the opportunity – i.e. imagine you see that you can buy the S&P 500 at a 20% discount. You will dive in. And naturally, the price of the ETF will recover pretty quickly. In this sense we can say flash crashes present an opportunity. It’s also worth noting that this can happen to any listed asset class- it is not a risk limited to ETFs. With index funds you don’t have this risk because the fund manager can freeze the NAV.
Could passive management grow to an extent that it skews price discovery in markets?
It is the opposite. In the past, smaller houses struggled to compete against big brokerages. With so much indexing, there is more incentive to dig deeper into the financials of smaller firms in the index to discover details that may have been missed. With indexing, concentration is on the largest companies, which reduces crowding in the small-medium sized segment leaving room for active managers to uncover information.
Do you believe that sustainable investment could be covered effectively by ETFs?
Yes absolutely. It all depends on how you use the data and using ETFs to provide an ESG product is not so different from what factor-Based indices are doing today. You can tailor-make rules about what to include and what to exclude, perhaps using ESG data providers. Of course ESG is a moving target, and you have the freedom to adjust these rules as there are more developments. Some ETF creators could focus on the theme of gender equality, for example, whereas some other companies may wish to apply environment factors to filter the universe.
Is the choice between active/ passive management affected by an investor’s investment time horizon (e.g. passive strategies are more aligned with buy-and-hold strategies?)
Like I mentioned before, active strategies require patience and a longer time horizon in order to produce alpha. There are two principle buyers of passive strategies – big institutions which tend to buy and hold, and retail investors who are more frenetic. Some investors tend to turn to ETFs to implement new ideas (thematics, etc) because it is relatively easy to go in and out of those products.
Do you have some kind of rules of thumb when it comes to passive products, for example, are there certain types you would never invest in?
We don’t have any dead set rules however we are much more cautious when it comes to synthetic basket strategies as the risks have to be fully understood. We look closely at the replication methodology as well as the cost (and that’s not just the cost of ownership, but also transaction fees).
What would be the rationale behind investing in a balanced portfolio of both passive and active investment products?
The ultimate balance between active and passive styles would depend on the characteristics of the security market, such as information costs, accessibility and overall market efficiency. Thus, in markets that are already deep and efficient, the returns to active investors‘ information gathering should be relatively low and returns to scale from passive investing relatively high, all else equal. Evidence in support of this view might be found in the fact that passive funds have been able to secure a higher share of equity market capitalisation in advanced economies than in Emerging ones.
This is also largely dependent on the investment time horizon (with active requiring more patience for outperformance). Some markets have a lot more visibility and data available and it is difficult to find inefficiencies to exploit, and so passive becomes more attractive. At certain phases of the cycle, using a passive product is effectively an active strategy.
What are the arguments (if any) against a 100% ETF portfolio ?
You are squeezed because everyone knows how you are invested – you are applying a rules-based approach whereby everyone knows the rules, thus eroding competitiveness. You will also probably be over-exposed to large-caps, when indeed small-caps tend to outperform over longer time frames. Small-caps require a lot more detailed analysis and forecasts are more important rather than pure data crushing.
For bonds it would probably also be advisable not to have a 100% ETF portfolio (because, based on market cap) you would be exposed to the most indebted countries or companies. By design, passive funds cannot express their disagreement with the decisions of individual issuers by selling their holdings. This might encourage leverage by borrowers. Because inclusion in bond indices is based on the market value of outstanding bonds, the largest issuers tend to be more heavily represented in bond indices. As such passive have bigger exposure to firm leverage than to firm size. Especially in murkier segments of the market such as EM debt.
Author: Group Investment Office