Commentary: Active investing v.2.0

Nobel laureate Bob Dylan's lyrics from his 1964 release "The Times They Are a-Changin' " are words every business leader should keep in mind when planning for the future: "… the present now will later be past, the order is rapidly fadin' …"

We believe this is even truer for the active asset management industry.

Over the past years, various advancements radically changed the telecommunications, technology, aviation, medicine and auto industries, to name a few. Think of the disruption Tesla is causing to the auto industry, the revolution Apple brought to the phone market, and the rebellion Amazon.com introduced in retail. Previously established players had to adapt to compete in the new norm of things. Those who didn't, disappeared.

A wave of change is coming to the asset management industry, which at its core has not materially changed its practices, processes and approach over the past decades. Still, a portfolio manager is in control of vast amounts of assets, following investment approaches that utilize financial information that is now standardized, common and well understood by most market actors. It should not be surprising then that long-term alpha generation has become so much more difficult.

In the meantime, demand for passive strategies from asset owners and retail investors has increased substantially amid supply growth from asset managers. The growth in passive investing is justified. It came as a response to the industry becoming fat, lazy and self-serving. Standard & Poor's research finds most active managers tend to underperform their respective benchmarks over medium- and long-term horizons. At the same time, way too many products charge high management fees while quasi-indexing and seeking to minimize tracking error. According to a Harvard University study, for every dollar managed by truly actively managed funds, there are $3 in index and quasi-index funds. And the majority of asset managers are compensated as bureaucrats: a flat management fee with no performance fees in place. Interestingly, on this last front, Abigail Johnson of Fidelity Investments recently slapped the industry in the face by admitting the lack of alignment with customers by announcing the introduction of fulcrum fees.

Does that mean active management is fading out? Yes, in the form we know it today. No, for managers who will develop capabilities enabling them to understand unstructured data and take better informed decisions.

How can managers differentiate themselves and ensure they are on the winning side of the equation? There are three forces we see acting as catalysts.

Many managers are still of the impression that integrating environmental, social and governance factors into their capital allocation process is purely associated with making their portfolios "greener" or more ethical. To us it is shocking that the overwhelming number of investors still make investment choices disregarding data around employee turnover and engagement, customer policies around product safety, environmental productivity as captured in energy, water and waste intensity of operations, and the governance and incentive structure that defines the culture of the organization. As with everything, the way a term is defined will determine how the term will be perceived. A sustainable company, from an investor's standpoint, is one that is managed in such a way that it is positioned for long-term success; a company whose management possesses the quality to understand and address short-term risks, and the drive to innovate to capture long-term opportunities. ESG data are the means that can enable an investor to understand a company's strategy, corporate purpose and management quality, at scale and in an unbiased, quantifiable way. Research suggests companies managed for the long run, exhibit better financial returns. As intangible assets increasingly dominate companies' balance sheets, and strategy becomes part of a company's valuation, ESG analysis will move financial analysis to business analysis.

The term "quant investing" is often perceived as intraday algorithmic trading where sophisticated systems try to identify arbitrage opportunities down to milliseconds. We define quantitative investing as an investment process that follows a rules-based, structured and consistent approach, which analyzes vast amount of data with the objective to take better informed decisions by uncovering hidden insights.

We as human beings have feelings and emotions. We evaluate gains differently than we evaluate losses using certain heuristics. Gains satisfy us less than (equal) losses hurt us. We have convictions and beliefs that lead to biases. And the more often we had been right in the past, the more difficult it is for us to realize the moment we are wrong. In addition, we have limited time during a day and limited capacity on the information we can assess.

A rules-based approach does not exhibit these human biases, does not build convictions based on intuition, is consistent in its assessments, can assess billions of data points and can explore different (known and unknown to us) structural combinations in short periods of time. It also provides an investor with transparency on the steps followed, the factors considered and the (consistent) reasoning an allocation was made. Technological advancements in realms such as big data and machine learning all have as an objective to improve our information environment and decision-making process, by addressing limitations we as human beings have. Active management in its traditional form will evolve to allow the integration of insights produced by such systems.

In the long past, managers were facing only one question: "how much return"?

Later, the question "how much risk?" was added.

Now, the question "how was the return generated?" is being added.

This last question is meant purely in terms of alignment between an investor's personal beliefs and her/his investments. Imagine a pediatrician that finds her pension is invested in consumer good companies that offer primarily high-sugar child nutrition, or a doctor invested in tobacco companies. Similarly, a materials scientist would be pleased to be invested in companies with exposure to advanced additive manufacturing or a security officer in companies offering security services. In the era of information and transparency, investors have started developing that sense of connection with their investments (pension and direct allocations). Investors have views and they want them to be reflected in the way they allocate capital. Thus, they will set managers responsible to ensure proper integration of those views in the way their money is managed. A huge transfer of wealth is in sight over the next years. Millennials are due to inherit trillions of dollars. They tend to view the world differently from their predecessors and they want their investment decisions to serve a wider purpose to continue legacies and protect reputations.

ESG analysis will not replace financial analysis. Similarly, machine learning will not replace portfolio managers.

However, managers who leverage ESG data along with financial data and utilize technological advancements will replace those who don't, to define active investing v.2.0.

Gabriel Karageorgiou is a partner at Arabesque Asset Management, London, and George Serafeim is the Jakurski Family Associate Professor of Business Administration at Harvard Business School, Boston. This article represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.