By Marlene Hassine Konqui, Head of ETF Research at Lyxor Asset Management.
Active management in ten years?
Passive or indexed investments provide low cost access to a very wide range of markets, and there’s next to no risk of them significantly underperforming the indices they track. So does that mean active managers’ days are numbered? We commissioned a research paper from the Lyxor Dauphine Research Academy – a partnership between Lyxor and Paris-Dauphine University’s renowned House of Finance – to try to find out.
Passive pushes forward
Index trackers are increasingly big business, but why has this kind of investing become so popular? In large part, it’s benefited from the steady, stimulus-fuelled rise of the markets over the decade since the financial crash. When markets are rising nicely, and the trends are clear, there’s little incentive to pay an active manager to try to eke out extra gains – especially when they could underperform significantly. For the advocates of active, the advent of more challenging market conditions in 2018 was a welcome chance for the managers to prove their worth.
If only wishing made it so
Yet for all the commentary at the start of the year about how uncertain conditions, a greater dispersion of returns and a re-focusing on company fundamentals would assist alpha generators, most active managers have so far singularly failed to rise to the challenge as our current Alpha/Beta Allocator makes clear. Results year-to-date show results are in fact weaker than they were in 2017 – with just 31% of European active managers outperforming, down from 44% last year. And those struggles are apparent whether you’re looking at equities or fixed income.
So will passive march on and muscle market share away from active managers? Not necessarily. Market directionality, or the likely lack of, represents a real challenge to this new hegemony but there are other issues at play too.
At Lyxor, we offer both passive and active funds. Of course, we’re big fans of passive – we’re one of Europe’s leading providers of ETFs, after all – but our research tells us active has a role to play too in any well-balanced, effective portfolio. Our research suggests the continued growth of passive will actually help, rather than hinder, active managers in time.
Changing the perception
The first of our papers explored the link between the past performance of active funds and subsequent fund flows, and also discussed how smart beta ETFs might affect investors’ perceptions of the performance of their traditional active managers.
It showed that the proliferation of these passive funds has increased competition among asset managers which has, in turn, assisted investors. Put simply, the greater availability of smart beta funds has forced active managers to demonstrate they can deliver true alpha – performance above returns generated by exposure not just to the market, but also to systematic factor risks – if they want to continue gathering assets. If they can show, and repeat, that skill, they have nothing to fear from the rise of the ETFs.
Is there an equilibrium level for active and passive?
The second of our papers dug deeply into the question of whether there’s an ideal balance between active and passive management, and whether the finding of that equilibrium would create better outcomes for investors.
It provides evidence that, at some point, the increasing use of passive funds could create more opportunities for active managers – helping them improve their performance and, in turn, increase the fund flows they attract.
It follows that there is a (theoretical) equilibrium market share for active and passive fund managers, although the researchers don’t seek to work out exactly what it is.
Are we close to reaching that equilibrium? Probably not. It’s quite possible the share of passive funds relative to active could increase substantially from here before active managers are able to exploit the informational inefficiencies necessary to consistently beat the benchmark.
The paper also helps address a criticism sometimes addressed at passive funds: that index trackers are misallocating capital because they invest in stocks without any regard for their price. The authors suggest any such effects should be corrected automatically. That’s because the growing market share of passive funds would create extra opportunities for active managers, helping bring prices back towards fair value.
A force for good?
Claims active asset management is in terminal decline are in fact exaggerated. In fact, the studies we sponsored show active management should actually benefit from the readier availability and greater use of passive strategies.
Ultimately, the increased role of index-based investing is more an opportunity than a threat for active managers. It creates a more effective equilibrium where each management style has a distinct role to play.
Based on the findings of our researchers we believe there’s an optimal split between active and passive management, and that the market will find it naturally over time. Contrary to the hype, the inexorable rise of passive isn’t, in fact, sounding the death knell for active managers, although “middle of the road” managers – those managing close-to-benchmark portfolios – may lose out.
The more investors move toward passive strategies, the more active managers should be able to outperform and therefore attract inflows, until the point where they can no longer outperform (because their informational advantage wanes) and flows move back into passive funds.
And of course passive and active strategies don’t act in isolation – there are external forces at play. Developments in the markets, for example, could have an impact on their performance potential and, in turn, how attractive they look to investors. Passive strategies have been helped by the market’s consistent rise over the past few years, but that won’t go on forever. We’ve already seen the return of volatility over the past few months, and that’s still the kind of environment that creates opportunities for the better active managers. There’s little doubt less effective managers will get left behind.
(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)