Like King Kong vs. Godzilla, the investment debate of active vs. passive continues.
I really enjoyed those cheesy old movies from Japan that pitted the two big monsters of science fiction. But as I recall, there was never a clear winner: Sometimes King Kong won the battle, sometimes Godzilla.
Similarly, the battle of active vs. passive continues. It seems like the battle has been won more lately by passive. In fact, in Exhibit 1, which charts the percentage of all active equity managers in the U.S. that beat their benchmarks over the past 25 years, we can see that passive has indeed been winning most recently. In fact, fewer than 50% of managers have beaten their benchmarks over each of the last five years, with the past fiscal year being the worst result. I charted these managers to be on a July 1 to June 30 fiscal year to be consistent with the fiscal years of most pension funds, endowments, and foundations.
We all tend to be influenced by what we see in our rear view mirror. To that point, we have all witnessed the miserable performance of active managers over the most recent fiscal year and this tends to color our expectations looking forward. Yet, there are sound economic reasons for this underperformance based on the current macroeconomic environment.
We are experiencing the lowest interest rates globally in more than a generation. More than $14 trillion of sovereign debt now has negative interest rates. Germany's and Japan's yield curves are both negative going out to 10 years — incredible. This leads us to conclude that bonds are “the new insurance policies.” Why? Because investors are willing to pay the government — in the form of negative interest rates — to take their money just for the guarantee that they will get that money back. This is the same thing as investors paying an insurance premium for the assurance of receiving their money back in the future.
With this in mind, boring, predictable, low-growth stocks like utilities have become “the new bonds.” With yields of 3% to 4%, utilities became a bond substitute. As a result, they were the best performing equity sector in the S&P during the 2015-'16 fiscal year with a 28% return — again, incredible. Unfortunately, because utilities are so boring and predictable, they are not well-traveled stocks for active equity managers.
At some point, interest rates will rise and utility stocks will go back to being boring, low growth and predictable. When this will occur, I hazard to guess on the exact timing. However, I am confident that eventually interest rates will increase to a more normal equilibrium and the macro environment will become more conducive to active management.
There is another reason institutional investors have become disenchanted with active management. Too frequently, active managers “hug” their benchmarks. Often this is rationalized as part of their risk management approach. But, this can lead to less risk taking and fewer active positions in the portfolio and more positions that are geared to matching the benchmark. Exhibit 2 demonstrates this point. The example is a well-known U.S. active equity manager with more than $14 billion invested in the presented active investment product. According to this manager's investment materials they are a “bottom-up, fundamental stock picker.”
Exhibit 2 plots the performance of this manager over four years relative to its benchmark — the S&P 500 stock index. Bottom line, this manager produces nothing more than a straight line vs. the S&P 500. In reality, they are a closet indexer, providing all beta and very little alpha. A key point is that “beta drivers” are linear in their performance. They perfectly match, in a straight line, the up and down movement of the underlying index.
Unfortunately, there are far too many managers that perform in this fashion, claiming to be an “alpha” manager while producing primarily beta. By the way, the manager in Exhibit 2 charges 85 basis points for this straight line.
Notwithstanding these headwinds, I do not believe active management is dead. Also, I don't view the active vs. passive debate to be binary — both can play a role in a well-designed portfolio.
First, in this low-return environment, capturing passive beta alone is unlikely to achieve the CPI + 5% returns that most institutional investors need to support their liability streams, budgets or spending schedules. Thoughtfully selected active managers — those that deliver alpha (often with some beta attached) — can provide a return boost to help achieve the CPI +5% goal.
Second, passive beta products can be used to implement thematic or tactical positions. For example, going long Japanese equities but short the yen has been a successful strategy to capture the upside of “Abenomics.” This strategy can be implemented through existing exchange-traded fund products.
Last, there is a new range of smart/exotic/alternative beta products that cheaply capture micro risk premiums that used to be the exclusive domain of hedge fund managers. For example, there are several ETFs that capture merger arbitrage premiums — long the domain of active management. This is a new area that is "quasi-beta" or "quasi-alpha" depending upon your point of view. Nonetheless, these investment products are a blend of active and passive — it is no longer a binary choice.
Institutional investors should absolutely demand more from their active managers when it comes to generating alpha. At the same time, they should prudently use the products and strategies available to cost effectively capture market beta in their portfolios.
In the end, it will require both to achieve the necessary returns to accomplish their investment objectives.
Mark Anson is chief investment officer of Commonfund, Wilton, Conn. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I’s editorial team.