A THIRD WAY IN THE ACTIVE VS. PASSIVE INVESTING DEBATE
It’s time we move beyond the Active vs. Passive Investing debate and bifurcated strategy labeling
The clarity once gained from what has become a messy strategy split has degraded beyond the point of helping investors in 2019.
We are now basing too much on a “two legged stool” and would have a stronger investment environment with a clear third option. We are ready to recognize and fully embrace formally adding Enhanced Passive to stand as a choice alongside Active and Passive approaches.
Passive strategies continue to show impressive gains in AUM and with the results in performance, in part aided by low costs, there are no signs this trend will abate.
According to data from Morningstar Inc., at the end of Q4 2018, U.S. Large-cap passive funds held $2.93 trillion in assets as of Dec. 31, compared with $2.84 trillion on the active side.
Distinct Third Strategy Type
There has been a relentless increase in passively managed funds with the emergence of a number of strategies that are really very different than traditional index tracking portfolios but which have been housed under the passive label. The time has come to support and highlight these different investment approaches by breaking them into their own distinct third strategy type.
Enhanced Passive would include most Smart Beta, Alpha, Factor Investing funds and potentially ESG and SRI strategies that are not actively managed by a portfolio manager. There has been a lot of interest in all of these new strategies but they have gotten a bit lost — I would argue without a clear place to call home.
For example, they suffer trying to live with being introduced as a “so called smart beta fund”. Enhanced Passive Strategy is a much clearer base from which to start educating and warming up what many believe is already the next big innovation in investing.
Many arguments have been made on the “merits” of a so called active approach to making portfolio investment decisions (a human portfolio manager is ultimately making buy, hold or sell decisions) vs. passive where (an index has been created and the investments track the index with changes following the rules set out by the index resulting in lower turnover and trading costs).
Active managers often leverage factor analysis and models in various ways to support screening, selection and to point at timing of trades. Both the DJIA and the S&P 500 have committees who ultimately make the decisions on inclusion and exclusions. Where a model is fully and systematically deployed this is usually a distinctly different approach than both passive and active management. Enhanced Passive occupies the space between the two and generally reflects the most promising research from many decades, which investors can access and assess on its merits. In the Enhanced Passive case the research is applied as an automated model to identify positions and make adjustments as and when specified over time within a fund. The formulaic model as created triggers the buy, hold and sell decisions.
Passive Investing Warning Signs?
A warning sign that the labeling is expiring is that we have heard industry participants, sometimes with a bit of glee, predicting passive investors will learn the hard way in the next market correction (that losses in passive strategies will be much larger than in actively managed portfolios).
There are many products labeled as Passive that would fall within the Enhanced Passive category, which for example are designed to reduce the risk of downside losses. Predictions have been made that people will pull out of passive more quickly (than active funds) in market downturns and make the market more volatile. In the short lived Q4 2018 U.S. equity swoon more AUM left active than passive. Active US equity funds in December of 2018 had $31.5 billion in outflows vs. passive funds taking in $45.6 billion (source – Morningstar data). The S&P 500 fell over 9% in the December after falling almost 7% in October.
The Federal Reserve Bank of Boston published a paper on August 27th, 2018 titled “The Shift from Active to Passive Investing: Potential Risks to Financial Stability?” One of the conclusions made was that passive investors are less reactive to performance. If we consider what might be inside the thought process of investor’s one conclusion may be that they see passive investing as being equal to lower risk. The word itself can be taken as being along for the ride but not needing to make as many specific decisions or commitments. There has been a lot of healthy education on how fees can add up and have a big negative impact on long term performance (with higher fees being connected to active management). Pressure on fees has been compacting differences and today the passive label does not always mean less expensive.
If Everybody Indexed
Investors have been bombarded with statistics on how most active managers underperform their index. For U.S Large cap it’s now been 9 years in a row of more funds delivering underperformance. Almost 65% of active (large Cap) managers performed below the S&P 500 for 2018 (as released in the annual report for 2018 recently provided by S&P Dow Jones Indices on how actively managed funds performed against their benchmarks).
“If everybody indexed, the only word you could use is chaos, catastrophe. The markets would fail.” Most will remember this statement made by the late John Bogle, founder of Vanguard, which has been at the forefront of indexing (low cost/low fee passive investing).
Bogle was speaking at the Berkshire Hathaway shareholder meeting in 2017. He was warning that there is a limit to the amount of passive investing a market can handle. We can summarize he did not want his legacy connected to what he feared was trending towards too high a concentration by a few large asset managers and one impact being outsized control over corporate governance (as a few large firms have been taking the lions share of ever increasing passively managed AUM).
The Boston Fed study mentioned above looked at that risk and a number of others. It is well worth a read given the number of perspectives evaluated. Interestingly most of the risks and potential negatives voiced don’t register and in fact in several cases the opposite has shown to be true.
Resistance is Not New
There is always some resistance and skepticism associated with big shifts or changes in how things are done. The evolution of passive investing started very slowly in the early 1970’s with Vanguard reaping both credit and assets has more than just come of age. Enhanced Passive as the next new thing in investing is not yet in the mainstream where investors can be best informed. Formal recognition and distinction is necessary.
Where a fund has an intention going beyond capturing market beta and intends systematically to do so without a portfolio manager making decisions let’s define this evolution as Enhanced Passive. The investing public would almost unanimously be interested in reading and hearing statistics about the approaches available in this evolving space. To date increasing allocation to Enhanced Passive strategies is occurring in Institutional and Wealth Management portfolios.
Competition among asset managers as they create new Enhanced Passive products has been fierce, innovative and healthy for the industry. We understand how and why Passive investing in well known index based funds with low fees has been a success for both investors and the asset managers who have efficiently offered them. Millennial Investors in particular have shown lots of interest and confidence in Enhanced Passive funds, which are driven by models where ESG and SRI factors are determining buy, hold and sell decisions.
Other factor-based, model-driven funds have focused on single factors such as value, momentum and quality. Multi-factor funds have become more widely available in new launches in the last two years. Just looking at one estimate of current market size $1.9 trillion (factor based investment funds) from www.blacrock.com heading to $3.4 trillion by 2022, interest and momentum is real.
By elevating the Active, Passive discussion to include Enhanced Passive it will create a more interesting discourse and investors will be well served as they increase their understanding, confidence and allocations to these strategies.
David Merrill – TechCXO partner in Boston