The New Thinking on Active Management
December 12, 2018
It’s hard to imagine that there’s anything more to say about the relative virtues of active and passive management. Everyone in the investment management industry knows the conventional wisdom on the subject, namely that index funds are a low-risk, all-purpose response to the supposed lack of value added by active management.
Active and passive aren’t in an adversarial relationship. Maintaining a balance between the two is important for the health of the markets.
But this conventional wisdom has been the subject of a significant re-examination in recent years, as attendees at the IAA’s View for the C Suite Leadership Conference learned.
In a session titled The Advantages of Active Management in a Powerful Portfolio, leaders from the academic community, the institutional investment world, and the asset management industry provided an overview of the new thinking on asset management.
The session was moderated by Rolf Agather, managing director of research at index provider FTSE Russell, with speakers:
- Professor Martijn Cremers of the University of Notre Dame, who summarized his newly published paper, Challenging the Conventional Wisdom on Active Management: A Review of the Past 20 Years of Academic Literature on Actively Managed Mutual Funds (co-authored with Jon Fulkerson of the University of Dayton and Timothy Riley of the University of Arkansas)
- David Lafferty, chief market strategist at Natixis, who reviewed his research on the value of active management in different market environments
- Scott Gonsoulin, investment manager at the Teacher Retirement System of Texas, who provided insights on the use of active management for the retirement system’s assets
- Anne Lester, head of U.S. retirement solutions at JP Morgan Asset Management, who discussed the role of active management in multi-asset portfolios.
Here are our key takeaways:
Active and passive are both important
Agather of FTSE Russell opened the session by addressing the obvious question: What is an index provider doing on a panel discussing the value of active management? Active and passive aren’t in an adversarial relationship, he explained. Maintaining a balance between the two is important for the health of the markets.
Active managers have a variety of skills and tend to make value-added decisions.
Speaking from a practitioner’s viewpoint, Gonsoulin of Texas Teachers argued that active management makes more sense in some markets than in others. For example, the retirement system has reduced exposure to active management in the U.S. equity market but continues to use active managers almost exclusively for non-U.S. stocks.
Lafferty of Natixis added that, because of the way that the indexes are constructed, there are systematic differences between active management and index funds. For example, active managers generally have higher exposure to smaller capitalization stocks than the indexes; as a result, active managers will tend to underperform when the biggest stocks are dominating returns but will outperform when market strength is broad-based. The performance differentials are “usually math, not magic,” he explained.
Active managers add value
The speakers rejected the conventional wisdom that active managers simply don’t add value for investors.
(F)ocusing on active versus passive within a single market may be beside the point… (M)ost investors aren’t interested in how their portfolio measures up against a market index. Instead, they want to meet their financial goals…
The recent academic literature finds that “after costs, many actively managed funds generate positive value for investors,” summarized Professor Cremers. That’s because “active managers have a variety of skills and tend to make value-added decisions.” He explained that active managers can add value in traditional ways – by picking stocks or timing the market – but that they can also add value in less obvious ways – for example, through corporate oversight or tax management.
Lafferty agreed that the conventional wisdom is based on old data. “Pressure from passive management is making active managers better,” he argued. Competition from index funds is driving down fees for active management. At the same time, active managers have become ruthlessly focused on the pursuit of alpha, by increasing the active component of portfolios and eliminating “closet index” funds.
Gonsoulin discussed how the search for value-added managers is pursued in practice. Texas Teachers looks for active managers who can generate alpha in excess of factor exposure through differentiated expertise. That might be through focus on a less efficient market or use of specific investment approach – but it could also be through traditional stock analysis supported by a high level of resources, experience and discipline.
Investors need active management to meet their goals
But, as Lester of JP Morgan Asset Management emphasized, focusing on active versus passive within a single market may be beside the point.
That’s because most investors aren’t interested in how their portfolio measures up against a market index. Instead, they want to meet their financial goals, and they will likely pursue those goals by investing in a multi-asset portfolio which will include real estate and private investments in addition to easily-indexed public market holdings.
It’s an active decision to use an index.
Yes, Lester noted, index investing can guarantee that clients will receive the benchmark return less the fee. But it can’t guarantee that they will reach their desired outcome, which might be a safe and secure retirement.
At the same time, buying an index may not provide the broad diversification that investors need. For example, the Bloomberg Barclay’s U.S. Aggregate Index – one of the most widely-used bond market indexes – captures only 52 percent of the U.S. bond market, not to mention that it emphasizes the companies with larger debt loads and bonds with longer durations.
Put simply, as Lester noted, “It’s an active decision to use an index.”
Videos of the presentation are available at www.activemanagers.com.