Dynamics Shifting – Active Vs Passive Management

Active or Passive management? Are both still keeping capital markets orderly?

The main difference between active and passive funds is that the former is managed “actively” by a fund manager seeking to outperform the market or asset class. By applying the “human factor” to asset selection, the manager will hope to provide greater returns than basically holding a selection of all the stocks/bonds in an index, class or region. Passive funds, offer investors similar levels of risk and return to the market they invested in. Over a certain horizon, however, they will underperform their benchmark due to their fund costs and overheads.

While this is an age old debate, the playing field is constantly shifting. Technology, macro events and demographics are all having more of an influence and guiding the opinion of investors both at retail and institutional level.

The investing world has changed dramatically since the credit crisis. Technological advances have continued to reduce trading costs in all markets and global central banks have embarked on and sustained zero-interest-rate policies. These Global conditions have resulted in a global market that is driven by broad economic announcements as opposed to government/company fundamentals. The evidence of this trend can be seen in the high correlations amongst sectors as they react as a group to economic news such as employment, interest or inflation statistics.

Active managers actively attempt to beat the market through selecting individual securities that they believe will outperform or by making tactical allocations to overweight or underweight a sector. Passive strategies can largely be thought of as trying to capture the performance of a particular market as a whole.

However, in this current turbulent environment where amazingly a rising tide has lifted all ships. It has been challenging for many managers that employ an active management approach. The current environment has compelled all managers to refocus on the factors that they can control: namely, costs, tax efficiency, and targeted market exposure. Why have we seen so many headlines recently announcing major cost cutting initiatives and office closing? Active management is expensive and organisations need to be able to justify their fee’s or feel the wrath of their investors through redemptions.

Another key factor is technology. In the hugely competitive mutual fund industry, it is difficult for managers to gain an information advantage and outperform. Some fund managers are better than others, but it might be difficult to identify them in advance by relying on their track records. A very small percentage do outperform!

In addition, to fund management fees, trading costs can also negatively impact a fund’s performance. High turnover can significantly detract from the performance of a fund over longer time frames. High trading costs make outperformance difficult in any market and that is why the advent of AI and AGI (Artifical General Intelligence) will be the biggest disruptors in the market.

So what destination is next? I believe a hybrid approach to investing will be the norm over the next 5-year horizon. AI and AGI will be a lot more involved in all asset classes and fee structures as we know it will be a lot lower. The robots are not taking over but they are going to be ever present and more relied on. The manager/institution that embraces both strategies with a compliment of AI and AGI will capture huge market share and will be the main frontrunner in our new investment environment.

Active Management:

Cons:

  1. Much higher fees due to more frequent trading and human management cost
  2. Paying professionals to manage your money in recent history has not been worth it across several asset classes and strategies.
  3. Potentially encourages “Bench Huggers” approach to active management -those managers that have “posed solutions as active but have ultimately delivered something close to bench.” –Ursula Marchioni, head of portfolio analysis and solutions at BlackRock
  4. Typically active managers hold more cash than do passive managers, which hurts returns. (negative interest rate environment)

Pros:

  1. The market is agnostic to everyone’s investment needs. With active management, you have the opportunity/flexibility to buy at better opportunities and entrance points.
  2. Active management creates a situation where you can avoid damaging downturns in the market and capture most upturns.
  3. Active management works well when the market is turbulent and you want to invest in different sectors and asset classes. (Euro crisis, Brexit)

Passive Management:

Cons:

  1. Despite keeping initial and ongoing costs ultra-low, passive funds won’t beat the market. Usually marginal.
  2. The world is moving faster, and investments need to be managed and adapted. Passive management does not give you the option for change.
  3. No protection against Black Swan (fat tail events)

Pros:

  1. Low costs and easy entry point.
  2. Many investors feel more comfortable with passive funds because they know what they are getting – an investment that aims to follow an index.
  3. Simplicity

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