The world's going passive. Is it a mistake?

The move from active to passive investing has been nothing less than seismic for the asset management industry. In the past 10 years, passive equity has gone from around a tenth of total equity assets to more than a quarter, and the momentum seems inexorable.

We believe there are many good reasons to invest in passively managed funds. For a start, about 70% of all equities are still actively managed, down from more than 85% 10 years ago. That means active equity effectively still is the market, and the market cannot beat itself, especially when you consider that active funds are shackled with management fees and other frictional costs of active management.

But while we find the reasons for the shift compelling, we offer three thoughts as to why we think this might not be the time to accelerate the move. We contend the balance between active and passive management is shifting in favor of active management.

If you'd had perfect foresight in March 2009 with the S&P 500 at a low of 667, you would have gone 100% long an equity exchange-traded fund and been done with it, and you would have been absolutely right. Assume you found a great long-only manager who you were pretty sure (but by no means certain) could beat the S&P by 300 basis points a year. You could just buy your ETF and compound returns at 20% annually for six years, or you could buy the great long-only manager and compound at (possibly) 23% for six years. The market's contribution to your return is 20% out of 23%. It's 87% beta and only 13% alpha, and the manager might not perform. Why bother with active equity when the equity beta offers such bounty? You wouldn't.

But that was then.

Now, after the S&P has trebled in price, most people would say the risk premium is somewhere between 2% and 4%. Add in the bond yield of 2% and your expected total return to U.S. equity is in the range of 4% to 6% per year. So now the picture is rather different. Your manager is still, you hope, going to deliver that 3% expected alpha on top, making your expected return 7% to 9%. This means your active manager could now deliver a third to nearly half of your expected return. Furthermore, if the beta available from passive equity is only 4% to 6%, this poses a major problem for institutional investors whose return targets are very often above that. U.S. endowments, for example, are required by law to pay out 5% of assets per year to maintain their charitable status. To keep assets flat in real terms they must achieve returns, most would assume, of 6% to 7% nominal at least. With expected returns in most fixed income markets far lower than that, and the equity beta probably below that too, business as usual (65% equity, 35% fixed income and other) won't cut it.

The picture has changed, and active might be starting to be worth the risk.

We think these moves in the alpha opportunity set are explained by sensitivity to macro events. When leverage is high, banks are undercapitalized, return on equity is low and the monetary transmission mechanism is broken. Markets are clearly highly sensitive to macro events, notably the actions of central banks and other authorities.

Take the case of the Italian banks. During the 2008 to 2012 period, what mattered for your stock performance wasn't whether you were a good Italian bank or a bad Italian bank — it's that you were an Italian bank! If macro improved, your stock rallied. If it deteriorated (and it generally did) your stock fell.

Since 2012, we observe that there is more dispersion between like stocks. See, for example, the outperformance of Intesa and Mediobanca since European Central Bank President Mario Draghi's “whatever it takes” speech vs. the halving of Banca Monte dei Paschi di Siena and the rather tepid returns to shareholders of Banca Popolare and Unicredit. We believe Alpha is returning.

Our final pushback against a wholesale move into passive equity is that we expect that the more assets are passively managed, the more opportunities for active managers there will be to lean against simple factor exposures.

The same criticisms that apply to simple market-cap-weighted indexes (they are price momentum-biased and take no account of valuation) might equally be leveled at a lot of other smart beta strategies. Take minimum volatility strategies for example. These were launched with great fanfare in May 2008 by MSCI (the first on the market), with compelling risk-reward characteristics in the back-tests. And while they have just about kept up with the total return benchmark over time, they have also had long stretches of underperformance. If it was an active manager, we believe you would fire it.

The final problem we see here is that, if you choose smart beta instead of pure index ETFs, taking money away from active managers still requires an active decision. That's because someone still needs to time the factors, for example from value to growth and vice versa, as the market cycle demands. Who is going to do that?

In summary, we believe there are both structural and cyclical reasons to look again at active managers, for whom the opportunity set is increasing as the global financial crisis recedes in the collective memory. The structural reasons are the return of dispersion and the opportunities thrown up by smart beta. The cyclical reason is that late in a market cycle the risk reward of active management improves, assuming that alpha is constant while beta is lower. And now having set ourselves the task, it is up to us to prove these assertions!

Ben Funnell is the lead portfolio manager of the GLG Euro Equity and Global Equity strategies and of the GLG Balanced Managed and Stock Market Managed strategies.