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Move to passive likely to build still more steam

But any paradigm shift is seen as a long way off

Charles C. Ellis
Charles C. Ellis believes managers’ attempts to outsmart the market are a losing proposition.

Active money managers could become victims of their own success at identifying mispriced securities.

And those with the least conviction could be the first to fall off the edge of the investment universe, analysts say.

Active managers have gutted their ability to deliver alpha to the clients paying their hefty fees, setting the stage for an accelerating shift to passive strategies, said Charles D. Ellis, founder of money management industry research house Greenwich Associates. (See related story: "Shift to passive may not signal prospects for alpha.")

In a Sept. 10 interview, Mr. Ellis said active managers as a group have become “so good at what they do” that individual managers are no longer able to “beat the crowd.”

While Mr. Ellis began making that point as far back as 1975, in a Financial Analysts Journal article titled “The Loser's Game,” his latest bite of the apple — a July FAJ article, “The Rise and Fall of Performance Investing” — comes as developments such as the rise of factor-based “smart beta” indexes and expectations of a long stretch of meager capital market returns look set to make life tougher for active managers.

The advent of “smart beta” over the past five years has left asset owners with a more complex set of options than the traditional “barbell” approach, with passive at one end and active at the other, said Peter Ryan-Kane, a consultant and head of portfolio advisory for the Asia-Pacific region, ex-Japan and Australia, with Towers Watson Investment Services, Hong Kong.

As investors gravitate to more cost-effective solutions — whether pure passive or factor-based exposure to value, size or minimum volatility — the market share of active managers should drop, predicted Chia Chin-Ping, MSCI Inc.'s Hong Kong-based head of research for the Asia Pacific region.

The scale of that decline could depend on how quickly active managers reinvent themselves, for example by offering strategies that tactically shift allocations among various factor indexes, he said.

Mr. Ellis said the shift by asset owners to passive from active — both traditional index strategies and exchange-traded funds — is accelerating, even if it remains well short of a paradigm shift.

ETFs driving growth

If statistics provided by the world's largest money manager, New York-based BlackRock (BLK) Inc. (BLK), are a reliable proxy, ETFs have been the bigger engine of passive growth.

For the five years through June 30, the share of ETFs in BlackRock's $4.3 trillion in long-term AUM jumped to 23% from 17%, while traditional index strategies rose to 43% from 41%. Active strategies, meanwhile, dropped to 34% of the total from 42%.

In an interview, Deborah Fuhr, managing partner of London-based research and consulting firm ETFGI LLP, said that as of Aug. 31, global ETF assets stood at a record $2.7 trillion, with record inflows of $185 billion for the first eight months of the year.

While precise data are not available, Ms. Fuhr noted that by some estimates, smart-beta ETFs account for more than $300 billion of that total, up from a negligible amount five years before.

Expectations for modest capital market returns over the next few years could add further momentum to the pickup in passive allocations, observers say.

In his latest FAJ article, Mr. Ellis said the correct way for asset owners to gauge what kind of value active managers are offering is to compare the incremental returns delivered over and above an index fund with the incremental fees charged. If expectations of low returns in the coming years materialize, the fees those managers command will look increasingly prohibitive, he said.

Michael Sebastian, a Singapore-based partner with Aon Hewitt, and head of the firm's Aon Center for Innovation and Analytics, said he agrees with Mr. Ellis that it's exceedingly difficult for active managers to provide alpha net of fees.

According to an analysis of a decade's worth of eVestment LLC performance data conducted by Mr. Sebastian and Sudhakar Attaluri, a senior consultant with Hewitt EnnisKnupp Inc., less than 2% of U.S.-based managers of active institutional strategies showed evidence of sufficient skill to provide alpha to clients after fees.

In contrast to Mr. Ellis, however, Mr. Sebastian said he believes that still leaves room for a minority of asset owners skilled at selecting active managers to successfully focus on active allocations.

He predicted that over the long term, the prevalence of portfolios containing big, passive allocations to markets deemed highly efficient, such as U.S. large-cap equities, and smaller, active allocations to less efficient market segments will give way to portfolios that are predominantly active or passive.

Asset owners skilled at picking superior active managers should go entirely active — both in allocations to alternatives strategies such as hedge funds or private equity, and to high-conviction, long-only traditional strategies, said Mr. Sebastian. Asset owners with no special skill at picking managers should go entirely passive, he said.

By contrast, Mr. Ellis predicted that attempts to outsmart the market — whether by picking stocks or tactical asset allocation — will prove a losing proposition over the long run.

While they expect passive strategies to continue gaining ground at the expense of active strategies, both declined to predict a dramatic change over the near term.

The shift to passive is likely to remain glacial for now, akin to watching a mountain move, predicted Mr. Ellis. Despite continued evidence of active management's failure to deliver, “not much has changed,” agreed Mr. Sebastian, even as he declined to rule out the possibility that low expectations for capital market returns could “result in a tipping point.”

Potential impact

Some asset owners see a smaller potential impact.

If markets and returns improve, that incremental increase in passive allocations could halt, said Charles Van Vleet, assistant treasurer and chief investment officer of Textron Inc., Providence, R.I., which has $10 billion in retirement assets.

Mr. Van Vleet conceded, however, that a growing number of corporate pension plans following liability-driven investment strategies could switch to passive from active as the growth portion of their portfolios shrink. At some point, “it's simply less worthwhile to dedicate time and resources to active manager selection,” he said.

Much of active management's staying power, said Mr. Ellis, can be attributed to a “can-do” spirit that leaves asset owners convinced that however shallow the common pool of alpha is, they can find managers capable of boosting their returns.

Asked how his belief in highly efficient markets can be reconciled with such recent market cataclysms as the tech bubble and the global financial crisis, Mr. Ellis said the market, while “latitudinally” efficient, remains liable to “longitudinal” mispricings. Other than by luck, it's impossible to successfully navigate such big market events, he said.

Some market veterans appear willing, if not eager, to try their luck should another runaway market environment develop.

Robert Prugue, a senior managing director of Lazard Asset Management LLC in Sydney with responsibility for sales and client service in the Asia-Pacific region, said asset owners that believe volatility is likely to pick up over the next few years and believe that returns aren't likely to be normally distributed can find reasons not to have passive exposure to markets.

David J. Holmgren, CIO of Hartford, Conn.-based Hartford HealthCare's $3 billion in pension, insurance and endowment assets, is one of them. “We're expeditiously taking down our passive allocations” now, he said, adding that “going active is the best risk option” when it's difficult to conclude that markets are factoring in broader macro risks. While noting that Hartford's portfolio is predominantly active now, he declined to provide a specific number.

Investors say the question of active vs. passive is a perennial topic.

“Our belief is that it's hard to identify skill in a manager” and, even if identified, it's “hard to capture ... so that you get the benefits of that” skill, said Matt Whineray, CIO of the NZ$26 billion (US$21.3 billion) New Zealand Superannuation Fund.

Towers Watson's research suggests that alpha exists at the asset-class level, said Mr. Ryan-Kane. But the question of whether institutional investors are set up to systematically capture alpha from managers — particularly when alpha at the specific manager level isn't stable — is a contentious one, touching on issues such as performance chasing and the transaction costs of hiring and firing managers, he said.

Two-thirds of the New Zealand Superannuation's portfolio is passive, and “we'll only step away from our reference portfolio if we're really confident that we can beat that benchmark — and it's not easy to beat,” noted Mr. Whineray.

When it comes to New Zealand's 70% allocation to global equities, “we can do active in two ways: either run that entirely actively, getting managers to pick stocks and hope to beat the benchmark, or we can change the weighting around that 70% — if markets are cheap, we can take it to 75%; if markets are expensive we can take it to 65%,” said Mr. Whineray. “That's exactly what we do with our strategic tilting program.”

This article originally appeared in the September 15, 2014 print issue as, "Move to passive likely to build still more steam".