Here’s a fact that doesn’t get enough attention:
By some counts, up to 86 percent of active funds underperform
their benchmark, but by definition 100 percent of truly passive
funds underperform theirs. Why is this? Because — unless
they are taking some type of an active bet or have zero
management and administration costs — they have to fall
short of their benchmark.
As the debate over
active versus passive investing continues, investors and
regulators alike are overlooking a key point: Passive investing
wouldn’t make anybody any money without active investing.
Passive investors are essentially free riders, piggybacking off
active managers at a fraction of the expense it takes to
research investment positions. No one in the investment press
focuses on this moral hazard or on whether or not this is fair
to active investors, who effectively subsidize their passive
brethren. The media question the value of active management,
but they never bother to acknowledge that without it passive
investment wouldn’t exist, let alone thrive. Passive
investors only make money if markets move, and active managers
are responsible for those movements.
Active investors undertake high-cost, high-value activities
(price discovery) that passive investors benefit from — at
a much lower fee. And they are taking full advantage: According
to Morningstar, assets under management in passive mutual funds
have skyrocketed 320 percent globally to $6 trillion since
2007. The growth of actively managed funds meanwhile has slowed
significantly, with a like-for-like growth rate of 54 percent
and total assets of $24 trillion.
The playing field has tilted in passive investing’s
direction, and if passive investors want to continue to thrive,
there must be a balance. Do regulators have a role to play
here? They ought to be more cognizant of the uneven playing
field when they examine how to regulate the markets moving
forward. We’ve seen regulators in Europe going after
investment fees for active managers, but why aren’t they
scrutinizing fees for passive funds that, it could be argued,
compete unfairly?
Active managers do need to take a hard look in the mirror
and reevaluate where and how they add value, perhaps starting
first with performance. One of the main reasons passive came
into existence and has grown is because active funds reduced
their raison d’être down to a quarter-over-quarter
benchmark comparison. It is a mathematical certainty that,
after fees, more assets will underperform the benchmark than
outperform. Is this really the best that active managers can do
to justify their existence? Whatever happened to the search for
growth and value and to the proper purpose of the capital
markets — to move capital to where the best risk-adjusted
returns can be found? This is how the profession of investment
management truly benefits society at large. Passive managers
play no role in this noble work.
The best active managers are those with a goals-oriented
approach that is focused on long-term objectives. Finally, in
this persistently low-interest-rate environment, active
managers will have to discover a fee model that is more
commensurate with the value they provide. Too big a percentage
of the investors’ returns is consumed by management
fees.
We are seeing a race to the bottom, of sorts, when it comes
to fees. Look at
Fidelity Investments. Long known for being an active
manager, the company recently announced it is cutting fees for
27 index mutual funds and exchange-traded funds to attract more
assets into passive strategies. You can’t criticize them
for the move: Investors have spoken, and increasingly they
favor passive funds over higher-cost active funds that
aren’t providing the value they hoped for. A spokesperson
for the company said Fidelity still “believes in the power
of active management.” It’s difficult to have power
without value.
Until the industry addresses this value question, I think
active management is doomed to continue to shrink. I’m in
good company: Larry Fink, CEO of BlackRock,
said last month he expects consolidation in the asset
management business because too many managers can’t
generate returns higher than their benchmarks and that the
shift to indexing will be “massive.”
Active managers need to reinvent themselves. They need to
focus on investment returns and not on growth of assets under
management. They need to experiment with portfolios that are
not constrained, have longer lockup periods and charge less.
And above all else, the word “benchmark” needs to be
removed from the active manager lexicon.
Paul Smith is president and CEO of the CFA Institute,
which has more than 140,000 members worldwide.