Over the past several years, strategies that replicate an equity index have attracted an increasing portion of investors' assets. According to the Investment Company Institute, so-called passive strategies now represent nearly 30% of all mutual funds and exchange-traded funds; this compares with less than half that amount 10 years ago. The trend toward indexing shows no signs of slowing. Casey Quirk, a practice of Deloitte Consulting LLP, predicts that by 2020, traditional active strategies will lose $1.9 trillion globally, while indexed strategies will gain $1.1 trillion.
The success of indexing has alarmed some market commentators. Traditional active managers evaluate each stock's true worth, which then helps determine whether a stock is included in a portfolio and, if so, at what weight. Managers of indexed portfolios, in contrast, hold all stocks in proportion to their index weights (more or less), regardless of their fundamental value. As assets flow to indexed from active strategies, the resources available to support fundamental research decline, as might the amount of value-relevant information reflected in stock prices. If indexing becomes dominant, these market commentators wonder who will conduct research and contribute toward price discovery to ensure markets are (nearly) efficient. In particular, who will parse companies' earnings announcements for insight regarding future performance? Who will assess a company's prospects for a new product or service? And who will determine the merits of a corporate restructuring?
The concerns captured by these questions are based on the premise that indexed investing will continue growing to the point where large numbers of active managers are driven from the market, and indexed investors are left to determine stock prices more or less among themselves. In our view, a capital market wholly dependent on indexers to determine relative prices would, indeed, not function well. But is it reasonable to worry that active investing will disappear?
We believe the threat posed by indexers is overstated. We agree indexed offerings will continue to take market share from many types of active strategies in the immediate future. However, we believe active investing will continue to play a significant role in the economy for many years, and that the potential impact of indexing on the long-term efficiency of the stock market is minimal.
There are three primary reasons for our abiding confidence in active management.
First, flows in and out of actively managed portfolios provide an incomplete picture of the quantity — or to be more precise, the intensity — of active management. What really matters is the level of disagreement among investors, and the extent to which these investors implement their distinctive views. We believe a manager's conviction, as reflected in a portfolio's tracking error (or, alternatively, its active share), provides a more direct indication of a manager's contribution to price discovery. Over the past several years, concentrated portfolios, including many hedge funds, have remained popular, while lower-risk actively managed strategies have experienced outflows. As an example, consider activist hedge funds, which pressure companies to change their corporate strategy and/or capital structure. Activist hedge funds, which take large positions in a small number of companies, have grown significantly over the past decade even as other active managers have lost assets.
Second, many indexed portfolios are, in fact, “active.” For instance, smart beta strategies, which have proved popular in recent years, follow well-defined and transparent sets of rules and offer exposure to common equity factors such as value, momentum and size. A large body of academic research concludes that portfolios formed on the basis of common equity factors have delivered higher returns and/or lower risk than the broader (capitalization-weighted) equity market. As smart beta portfolios tilt away from the cap-weighted market and toward common equity factors, they can push stocks toward their fair-market value and thereby help eliminate persistent sources of mispricing, just like other actively managed strategies.
Third, many investors use indexed portfolios to express tactical — i.e., “active” — views. As economic conditions evolve, asset allocation models and other outcome-oriented strategies, for instance, rebalance opportunistically from bonds to stocks, or shift assets among sector and/or style funds (small cap vs. large cap, or growth vs. value). The resulting trades can help eliminate relative mispricing across groups of stocks. ETF strategists use a diverse universe of ETFs to create multiasset allocation portfolios, whereas other types of allocation strategies might include mutual funds or (customized) separate accounts. With multiportfolio strategies, the individual stocks within a given portfolio may be weighted according to an index, but stocks' weights in the composite portfolio can deviate significantly from those of the market. In this way, the overall (combined) strategy is very much active.
As highlighted above, we do not believe the growth of index investing poses a serious threat to the efficiency of the capital markets. Although indexed offerings likely will remain popular for the foreseeable future, relatively few investors will adopt a pure indexing approach to their overall portfolio, in our opinion. Rather, we believe investors will continue to build portfolios that express a variety of “active” views, either to exploit temporary opportunities in the market, to dynamically adjust their risk exposures, or simply to better meet their own unique long-term investment objectives.
The enduring appeal of active investing does not mean, however, that managers of conventional, stand-alone active equity portfolios can relax. The flows out of actively managed portfolios are large and persistent, and this is forcing many active managers to justify their investment methodology.
Given these challenges, what should active managers do?
In the future, we believe that successful active managers will focus on one or more of the following key areas:
- Innovation: Investing is a highly competitive activity involving large numbers of talented, diligent and nimble players. Success requires deep and unique skills, and a commitment to stay a step ahead of others. To maintain their edge, some managers will seek to differentiate their investment process by making greater use of technology designed to process large quantities of unstructured and alternative sources of data. Such data can include various types of text, information about web traffic, and video and satellite images. Other managers might emphasize speed to exploit data more quickly than other market participants. And still other managers might create new structures such as non-transparent active ETFs, which deliver a manager's investment insights via the convenience of traded funds. Most likely, there is no single “best” approach; rather, each manager will need to form his or her own plan, one that is compatible with the manager's specific skills, philosophy and opportunity set.
- Portfolio implementation: Investment insight, as reflected in thorough security analysis, is a critical component of good performance. But outstanding research is not, by itself, enough. Efficient portfolio construction and trading is also essential. Investors, even those with deep and sustainable investment insight, can underperform if their portfolios have incidental, uncompensated factor exposures that dominate returns. For instance, a high-growth “quality” portfolio might have large sector exposures that can drive returns even if the stocks within each sector add value. In addition to portfolio construction, managers need to be mindful of transaction costs, not just when executing orders but also when selecting stocks and sizing positions. After all, every basis point saved in market impact is an additional basis point of alpha.
- Asset allocation strategies: As explained earlier, some of the flows into indexed portfolios and out of stand-alone active portfolios reflect a shift in the scope of active management rather than a decline in the overall quantity of active management. Asset allocation strategies often use indexed products to express specific investment views, resulting in large deviations from a pure cap-weighted allocation. Active managers can contribute to the growth of these strategies in at least two ways. First, managers can develop their own asset allocation models, be they tactical (opportunistic) or more strategic. To be sure, developing an effective asset allocation model is not easy, and might require that managers expand their expertise, but doing so could be highly rewarding given the strong demand for outcome-oriented investment solutions. Second, managers might be able to contribute to the growth of asset allocation strategies by creating products that are suitable components of a multiportfolio approach. Smart beta portfolios, given their transparency and low cost, along with other types of portfolios that offer well-defined and stable factor exposures, could be suitable building blocks for an asset allocation strategy.
The steady flows to passive strategies has led some commentators to conclude investors are losing confidence in active management. In fact, we believe investors' views about active management are more nuanced. The strong demand for concentrated (specialty) strategies, smart beta portfolios and solutions-based asset allocation products suggests that while the scope of active management is evolving, many investors remain committed to active investing more broadly. As this change occurs, however, many conventional active managers might struggle. In contrast, active managers who embrace the latest trends, and focus on areas such as innovation, portfolio construction and multiasset strategies, have the potential to do well.
For this reason, we are optimistic about the long-term prospects for active management and are not concerned that indexing poses a threat to the proper functioning of the capital markets. Of course, stock prices do and will deviate from their fundamental values, but if and when mispricing occurs, we do not think it will be due to the growth of indexed investing.