The inexorable shift toward passive products is undoubtedly the most dramatic change in asset management since its inception. It has captivated the mainstream financial press to the degree that no story can be written about the industry without referencing its rise to prominence.
When you look at the raw inflows it’s hard to argue with this. Examine active and passive flows over the past five years and the change is startling. In 2012 and 2013 both were taking in annual flows in excess of $400 billion. But by 2014 momentum had switched firmly to passives, which enjoyed inflows of more than $600 billion, while money into actives started slowing, culminating in last year’s $253 billion outflow.
Given that we are in the midst of a nine-year bull market for equities – normally a time when the active industry profits the most – the trend is even more marked.
Moody’s anticipates that some time in the middle of the next decade, passives will overtake active as the dominant form of collective investment.
Why has this happened? First and foremost, it’s down to technological innovation. We now have the ability to track and package any index into a relatively cost-efficient vehicle. This is exactly the same kind of disruption from technology that we have seen from the likes of Airbnb in the leisure industry and Uber in transportation.
The second reason is the lacklustre performance of fund managers globally in recent years, a phenomenon extremely well covered by the mainstream media. Looking at outperformance figures globally from all 15,000 fund managers Citywire tracks, we can see a sharp downturn.
Figure 2 shows cumulative net flows for active and passive funds over the past five years, together with the percentage of active managers outperforming in each year in the bubbles.
All starts out relatively well, with outperformance above the 40% mark. While this is short of the magic 50% number, with strong due diligence it’s possible to argue fund buyers would more likely than not be picking outperforming strategies.
But 2014 and 2016 represent particularly poor years, with just a third or less of active managers outperforming the market. These years are the worst for active managers since Citywire started tracking them in 1999, and I would wager they could be the worst of all time.
Longer-term figures look even worse: over three years until the end of 2016, only 27% of active managers added alpha, while over five years just over a third managed this feat.
Not all asset classes are equal
It’s well known certain markets are extremely challenging to outperform, such as global and US large-cap equities. These sectors account for 14% of the managers we track globally and looking at performance doesn’t make for pretty reading (see chart on page 24).
Fewer than one in 10 US equities managers managed to outperform the benchmark over three years, with just 17% managing to do so in global equities.
The picture doesn’t look much brighter over seven and 10 years. The real experience of investors is likely to have been even worse, with underperforming funds that have been closed not reflected in the figures.
Say you decide that, given this track record, you invest passively in US and global equities. What of the rest of the investment world? If these two problem sectors are excluded, does that improve the broader picture for active management?
Not really: the numbers shown in the bubbles in figure 2 just move up by a few percent, but not enough to change the narrative. This reflects how tough active management has been over the past few years. An exchange-traded fund doesn’t care about interest rate uncertainty or political risk – it just tracks its chosen market. It doesn’t try to defend investors’ wealth by taking our protection, then seeing this strategy punished as the bull markets in both bonds and stocks gathers strength.
But should we be defining success as outperformance? After all, investors can’t buy the market, only passive funds that track it. The fees these charge, however small, mean they are guaranteed to underperform, unless they engage in stock-lending or portfolio optimizing, arguably a move away from pure passive exposure.
What if the true gauge of an active manager was their ability to outperform these passive products?
I started looking at what percentage of managers outperform when the information ratio turns ever-so-slightly negative. Just a -0.05 or -0.1% movement, to reflect the actual performance of passive products, has a dramatic impact (figure 3). Over three years, nearly half or more of active managers outperform, while over five years the proportion reaches as high as two-thirds on this measure.
There was a cluster of fund managers who had just fallen short of their markets. This completely changes the narrative.
Why haven’t we heard this before? Because active managers don’t like talking about underperformance, a trait shares with the passive industry.
I believe it is up to us to move away from benchmarking funds against an index, which is for all intents unattainable, and toward benchmarking them against passive options. This is a natural reaction to technological disruption and one I’d like to see embraced by all data providers, including Citywire.
How do we do that? Do we take the composite of relevant passive products, or follow where the average dollar is invested? A good start would be to simply commingle our peer groups with products from both sides and let investors see what the reality is.