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LARGEST MONEY MANAGERS: Active vs. passive

For international strategies, active management is king

Passive investing takes crown for domestic assets but more is preferred across borders

Jay V. Kloepfer, Callan
Jay V. Kloepfer said active managers have a much better chance of doing well when they aim their investing acumen at international small-cap stocks and emerging markets.

Passively managed strategies continue to outpace active strategies domestically. But for international investments, it's a different story.

Data from Pensions & Investments' annual survey of the largest money managers of U.S. institutional tax-exempt assets show passive U.S. equity assets went up 25.6% in 2017 vs. 11.4% for active strategies. Passive U.S. fixed income rose 16.1% vs. 2.5% for active.

But this has not been the case on the international side, where over the past few years the percentage growth for active strategies is very similar to passive, for both equity and fixed income. Active international equity was up 23.6% on a year-over-year basis, while indexed international equity went up 24.7%. Active international fixed income was up 8.8%, vs. passive international fixed income growth of 7.9%.

Active global equity growth was higher than passive in the past year — 24.97% vs. 12.9%, respectively. P&I's data reflects investors' continuing focus on fees in domestic strategies, consultants said. Also, it's easier for managers to find alpha overseas than it is domestically.

"Active management is more successful when the mandate is broader, when there are more places to invest, more levers to pull," said Jay Love, partner, U.S. director of strategic research, Mercer LLC, Atlanta. "Therefore, we tend to recommend active management more within international equity."

Mr. Love added that he attributes the growth in international active management to "more differentiation and more places to add value."

The Mercer consultant called the U.S. market the most efficient in the world, which is why it's difficult for active equity managers to outperform and why Mercer consultants tend to recommend that their institutional clients seek passively managed domestic equity strategies.

But for fixed income, Mr. Love said he believes continued growth in passive domestic strategies might "just mean there's a general trend among investors toward passive in the U.S. that's not driven by performance."

So, while it makes more sense for investors to seek passive equity domestically, it's a safer bet to seek active equity overseas.

"With international small cap and emerging markets, there's so much more to cover, more potential for active to do well. It's almost impossible to buy passive international small cap," said Jay V. Kloepfer, executive vice president and head of capital markets research at investment consultant Callan LLC, San Francisco.

Although there is an emerging markets index Mr. Kloepfer noted it's "hard to replicate" and "has a lot of wacky things going on with it."

Russell Ivinjack, senior partner at Aon Hewitt Investment Consulting Inc. in Chicago, agreed investors "thinking globally ... has led to increased flows" into actively managed overseas mandates. "I think we will continue to see the increased use of passive in U.S. equities. Investors are accessing U.S. equity beta as cheaply as possible."

Kevin Quirk, principal at money management consulting firm Casey Quirk, a practice of Deloitte, Darien, Conn., said the largest movement toward passive domestically "is in the U.S. large-cap equity market." And a major challenge that money managers are facing with the continually growing passive appetite is how it can substantially erode revenue growth.

Analysis by Casey Quirk released in March showed that although assets under management for the publicly listed money management firms surveyed by the consultant ​ increased 16% in 2017, organic growth from net flows remained at 0.03%.

And although operating margins rose to 31% in 2017, up from 29% in 2016, revenue only grew 11%, largely due to fee pressure.

"Every dollar that moves from active to passive is massively reducing the management fee revenues," Mr. Quirk said.

Although most consultants with whom P&I spoke said they don't expect to see a passive boom for non-U.S. equity or bonds in the coming years, Callan's Mr. Kloepfer suggested it could be possible if international markets become more efficient.

"Remember, 15, 20 years ago no one did anything passive overseas. But now, big funds may have some passive (assets)," Mr. Kloepfer said. "As people get more work in overseas equity, it'll take hold."

He provided the caveat that if this growth in indexing were to happen, it would most likely to be with equities, since on the fixed-income side, credit requires a lot of research. "More (fixed-income) mandates overseas are active because (investors) think there's something to be had there," Mr. Kloepfer added.

Mr. Quirk argued the growth of "passive in international market is quite robust," depending on how far back one looks. "If you go back two, three, or even five years, the passive numbers are up quite a bit," he said. "Depending on (how much) outperformance by active managers in these other (international) markets shrinks, you would expect to see a more passive investing approach in these places."​