Active managers are coming under greater pressure as index funds knock them for six
by Anthony Hilton FCSI(Hon)
Passive management means that investors simply buy a fund that replicates the index. Active management tries to find those shares which will outperform, and buys them. In theory, active managers should beat the trackers all ends up. But it does not work out like that. In practice, indexing is now all the rage.
The first index tracker was launched in the 1960s, but it took a long time to get anywhere. Wells Fargo, the pioneer, started with the Samsonite pension fund, but only US$6m was pledged in 1971.
Others followed, including the late Jack Bogle, the founder of Vanguard. He wrote his thesis on passive management in the late 1950s, but it was almost 20 years before he put his ideas into practice. He launched in the mid-1970s and had a princely US$14m in 1976. Even in 1982, he only took US$100m and it was not until 1988 that he reached US$1bn. By 1996 he had raised US$10bn. Today, his main fund is worth US$400bn.
Exchange-traded funds (ETFs) have had an even shorter life, though they have made up for it since. The first was launched by the Toronto Stock Exchange in 1990. Nate Most, for many the father of ETFs, actually launched his S&P 500 product in 1993 at State Street, the US bank. It has grown to US$265bn and the overall ETF universe is now an astonishing US$5tn.
ETFs and index funds together are now worth US$10tn globally, or as much as private equity and hedge funds combined, and roughly 30% of the US fund management universe.
Particularly in recent years, active management has been knocked for six. According to Rathbone, the UK wealth manager, in 2015 ETFs attracted US$200bn in the US while actively managed strategies saw outflows of US$124bn. It was the same story in bonds. ETFs took US$41bn in the first three months of 2016 whereas active funds lost US$16bn.
Since then, the trend has continued. Even if they are not quite as entrenched in the UK, index products are catching up fast.
This is no surprise. Index funds have most of the academic research with them. Eugene Fama’s Efficient Market Hypothesis, William Sharpe’s Capital Asset Pricing Model, and Harry Markowitz’s Modern Portfolio Theory all lend weight to passive investing.
So too does Warren Buffett, perhaps the world’s greatest investor. He not only recommends trackers to everybody who cares to listen, he also took a ten-year bet with hedge fund manager Protégé Partners to prove that the ‘hedgies’ (a hedge fund manager), with their active management, would underperform. His annual management letter in May 2018 said that the tracker delivered a performance of 126% whereas the active managers returned 36%.
Even more scathing was a
Wall Street Journal article, which said: “Santa Claus and the Easter Bunny should take a few pointers from the mutual fund industry. All three are trying to pull off elaborate hoaxes. But while Santa and the Bunny suffer the derision of eight-year-olds, actively managed stock funds still have an ardent following among adults.”
The trouble is that most active fund managers do not beat the index once their fees are taken into account, so even if trackers go down, active managers do too.
Luck rather than skill accounts for many of those that do outperform. Managers need at least a 15-year period of outperformance to confirm that there is skill there, which means, in effect, that it can’t be verified because firms are not going to wait that long.
Active managers protest
But active managers say they do better than it appears. From 1997 to 2014, Invesco surveyed a range of active funds and proved they were better than trackers. In particular, they do better in bear markets, it is said. The trouble is that someone else always has a different theory, or a different set of benchmarks, that tend to prove the opposite.
But perhaps active management will have its day if, as seems likely, there is a downturn in equity markets. In particular, Zeno Staub, chief executive of Vontobel, the Zurich fund manager, says indexing fails to distinguish between companies with the best environmental, social and governance credentials and those that are just scraping by. Clients want more than a ‘computer says no’ exercise from their investments. They want conviction to avoid doubtful sectors and to sleep well at night.
But it is getting harder. They say poker players need more skill once the dumb money has been taken by the good players. It is the same with active managers, who will find it harder to make money because the poor active managers will have given up.
Jeremy Grantham of GMO, a Boston money manager, says this logic will hold until index funds hold 90% of the universe. “Asset management is getting tougher and tougher,” he
told the
Financial Times. “The argument that it will become easier is nonsense.”
The original version of this article appears in the Q1 2019 print edition of The Review. All members, excluding student members, are eligible to receive the quarterly print edition of the magazine. Members can opt in to receive the print edition by logging in to MyCISI, clicking on My account, then clicking the Communications tab and selecting ‘Yes’.
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