The dearth of alpha on tap today — the result of a critical mass of smart, motivated people dedicating their lives to stock picking — should persist even if a wave of passive investing were to sweep a healthy chunk of those people out to sea, two experts say.
Both Michael Sebastian, a Singapore-based partner with Aon Hewitt and head of the Aon Center for Innovation and Analytics, and Charles D. Ellis, founder of money management industry research house Greenwich Associates, say several factors have slashed the proportion of active managers capable of covering their fees over the years. Among those factors are increased competition, technology that makes information more abundant and regulation meant to provide investors with equal access to market-moving news.
If cutthroat competition has powered the market's efficiency, then a shift to passive investing significant enough to result in a major culling of active managers could be expected to improve the alpha prospects of survivors.
But both analysts contend that a fairly significant move to passive could occur without weakening active management's “price discovery” muscle, or reversing alpha's downward spiral.
In a footnote to his July Financial Analysts Journal article titled “The Rise and Fall of Performance Investing,” Mr. Ellis wrote that even if 80% of shares listed on the New York Stock Exchange were indexed, indexing would still represent less than 5% of annual trading. “It is hard to believe that even this large hypothetical change would make a substantial difference to the price discovery success of active managers,” he added.
In an e-mail, Mr. Sebastian predicted the trend toward “more efficient and effective price discovery will continue” whether or not the shift to passive investing picks up dramatically. If passive allocations do gain considerable ground at the expense of active strategies in the years to come, it's likely to be the low-conviction benchmark huggers that are driven out of the market.
“It's the unskilled manager group that will decline, while indexing and high-conviction, skilled active management rises,” and those skilled managers “will continue to get better at what they do as technology and financial instruments continue to improve,” he predicted.
Others expect a more fluid alpha environment in response to shifts in the balance between the industry's active and passive segments.
“I'd rather everybody else moves into passive because that would give my managers more scope to find mispricings,” said Elspeth Lumsden, the Melbourne-based head of equities with Australia's A$101 billion (US$91 billion) Future Fund.
Rather than target a specific mix of active and passive strategies, Ms. Lumsden said the Future Fund team makes judgments on the best way to get exposure for each allocation. The current mix is probably roughly 60% active and 40% passive, with the passive total including allocations to factor indexes as well as futures for the fund's overlay program, she said.
That passive allocation could edge up should the Future Fund find new factor indexes to allocate to but “we've certainly got no plans to actively reduce active management,” which should continue to offer good value “as long as you've got the internal team to be on top of your managers ... and really understand the return stream you're getting (from them), she said.
Some managers say their ability to add alpha might already be benefiting as a result of attrition following the global financial crisis.
Outperformance by quant equity managers has picked up considerably in the past three or four years, and the fact that the quant space has become a lot less crowded now has contributed, noted Michael Even, president and CEO of Boston-based Numeric Investors LLC.
