Asset Allocation

In August this year, passive US equity assets under management (AUM) surpassed those in active funds for the first time. As the popularity of passive investing rises, some investors are asking whether this represents a structural trend away from active stock picking or if it’s a cyclical preference that will reverse as conditions inevitably evolve. If one of Australia’s biggest wealth managers, the Future Fund, believes it’s prudent to shift its domestic equities allocation more in favour of “passive or factor and rules-based approaches”, should individual investors who are less resourced follow suit?

This month we frame this debate with the above question in mind, focusing particularly on the domestic equity market. While our title implicitly pits one strategy against the other, we believe that when constructing portfolios, these strategies should increasingly be viewed in a complementary light and seen through a more nuanced lens that accounts for alpha capture, factor and style exposure, diversification benefits and, of course, fees.

What is active and passive investing?

Active investing occurs when an investment team builds a portfolio based on research and analysis with a specific investment objective in mind (typically to outperform a benchmark). At its heart, active management believes markets are inherently inefficient, and that pricing and value anomalies can be exploited to achieve above-benchmark returns.

Passive investing is underpinned by the belief that a stock's current price reflects all relevant information about its current and future earnings (the efficient markets hypothesis). In this case, the best strategy is to buy and hold a diversified portfolio and minimise trading costs. Passive investments, therefore, typically track an index of securities for a comparatively low fee. While these products can have various structures, such as unlisted managed funds, they more frequently take the form of exchange-traded-funds (ETFs).

In the US, passive equity funds now make up slightly more than 50% of total equity AUM compared to 5% in 1995. For US bond funds, it now stands at 26% compared to less than 5% in 1995. Passive AUM shares have also risen in other regions over the past decade, most notably in Japan in both equities and bonds, and in recent years in emerging markets equities.

In Australia, there has also been substantial growth in ETFs, which are a reasonable proxy for passive investing locally. In 2019, the Australian ETF market hit AUD 50 billion in AUM (almost triple its AUD 18 billion in 2015), with around 200 ETFs currently listed. Most of this growth has been in equity-type products. The local ETF market remains small in the context of the USD 1.7 trillion in AUM as at March 2019, but its growth is noteworthy.

What has been driving the recent trend toward passive?

Despite a range of explanations for the shift toward passive investing, most studies default to two main reasons—namely, performance and fees.

Performance—A likely driver of the growth in passive AUM has been the lacklustre performance of active managers. One barometer for this is the so-called SPIVA report (S&P Dow Jones Indices Versus Active), which compares returns of active funds against their respective benchmarks. 

As shown in the following table, in the 10 years to mid-2019, more than 83% of domestic equity funds have underperformed their benchmark.

This is consistent across the globe with similar (though less severe) underperformance in Japan, Europe and the US. Indeed, after fees, most active managers have underperformed their relevant index—across time periods, countries, and asset classes. This recent poor relative performance has driven investors to seek passively-managed funds as an alternative.

Percentage of domestic funds that the index outperformed 


Fees—A second factor is the role of management fees in return outcomes. Passive investments, typically ETFs, mostly charge lower management fees compared to active products. The shift toward passive investing is likely as much to do with investors seeking lower fees as it is with performance.

The cheapest passive product in Australia is the BetaShares Australia 200 ETF A200, at 7 basis points (bps). However, many purely passive products charge between 20-40bps in management fees, compared to an average of almost 1.5% for domestic equity managers. This difference can have a material impact on cumulative returns over the long term.

In what environments can active strategies outperform?

In defence of active investing, proponents often default to rhetoric around the exposure of passive investments during market drawdowns to stocks with stretched valuations, weak fundamentals and crowded positioning. As we saw in 2010 and 2013, flash crashes can pose a risk to liquidity and performance for passive investors. According to JPMorgan’s Global Head of Quantitative and Derivatives Strategy, Marko Kolanovic, “This shift from active to passive, and specifically the decline in active value investors, reduces the ability of the market to prevent and recover from large drawdowns.”

However, our analysis, which reflects more underlying fundamental characteristics, suggests there are three scenarios where active investing typically outperforms for the domestic market—when dispersion is high, when stock correlations are low and during market downturns.

1. Active investing outperforms in high dispersion markets

Our analysis reveals that when return dispersion is elevated, active managers typically outperform. Return dispersion is driven primarily by uncertainty in underlying market earnings. And in a world of structurally lower growth, this should drive higher dispersion and a better environment for active managers. Corroborating this, the left-hand side panel of the chart below shows S&P/ASX 200 active outperformance rising as return dispersion increases.

The charts reveal two further key observations. Firstly, since the turn of the century, dispersion has been broadly trending lower, albeit marked by periods of significantly higher dispersion. Since the GFC, short-term increases in dispersion have not been as pronounced as in the previous period.

Secondly, the right-hand side panel of the chart shows that dispersion for the S&P/ASX Small Ordinaries index is considerably (and always) higher than it is for the S&P/ASX 200, suggesting that this is a segment of the market that is more conducive to active management. 

Active outperformance rises as return dispersion increases 

2. Active investing outperforms when stock correlation is low

When the correlation of returns is low, this allows for unique insights to be used in the stock selection process. However, as UBS highlights, only in instances of bottom quintile correlation have active managers in aggregate beaten their respective benchmarks.

As the chart below shows, in a world where stocks are driven by a common factor, it is difficult for an active manager to outperform. This is why low pairwise correlation matters. Unfortunately for active managers, since 2007, macro- economic factor risk has driven correlation to historically high levels. Of course, there is no certainty that this environment will continue indefinitely. 

As correlation increases, active manager outperformance decreases 

3. Active investing outperforms during market downturns

As risk markets extend, capitalisation tends to concentrate in a few sectors and market breadth declines. A reversal in markets can create issues for passive investors, as they invariably have full exposure to the largest sectors at the peak. Active investors with appropriate risk management and sector positioning can add significant value by recognising extreme sector rotations that accompany bull-to-bear market leadership shifts.

Passive strategies are unable to take advantage of this trend as they funnel money into a narrower set of securities. As an example, during the 1974-82 cycle, the energy sector’s share of market capitalisation peaked at close to 27% before falling to 16% by 1983. The technology sector peaked at 29% in 1999 before troughing at 14% in 2002. More recently, the financial sector peaked at 22% in 2006 before troughing at 15% in 2008 during the GFC. 

Active manager excess return during major drawdowns 

For Australian investors, the above chart shows that during periods of market turmoil active management does appear to generate excess returns, with four out of the five most recent market corrections resulting in active management protecting capital better than a passive investment strategy.

This gives rise to the notion of sequencing risk—that is, the risk involved in the timing of investment returns. A portfolio suffering significant drawdowns in the 10 years prior to retirement—or the 10 years post retirement—may irreversibly damage future returns. Given that active managers deliver most of their excess returns during periods of high return dispersion (typically periods where the market draws down), a good active manager can help mitigate sequencing risk. This suggests the active versus passive decision should at least be informed by market cycle analysis.

Finding the right ‘active versus passive’ balance

Recent headlines that suggest ‘active management is dead’, are almost certainly premature. Still, active equity managers have increasingly struggled to outperform their benchmarks over the past couple of years. And there is little doubt, as we have discussed, that some of the key drivers for active outperformance remain under pressure—namely the lack of dispersion, the concentration of macro factors and the low volatility in overall market trends.

We believe, however, there will be sustained periods ahead where the current headwinds for active investing will fade, and potentially powerfully. With the macro and market cycle in its later stages, the likelihood of a significant risk drawdown inevitably increases, an environment where there must also be some uncertainty surrounding how the recent global increase in exposure to ETFs will impact relative passive investment performance and liquidity.

From a portfolio construction perspective, it is also important to remember that the recent sustained outperformance of passive strategies has its epicentre in large-cap developed equity markets. In contrast, active investing retains its place of prominence where idiosyncratic risk and the cost of information is high. This includes less developed equity markets (such as emerging equity markets), small to mid-cap equity investments, as well the broad gambit of alternative investments (private equity, hedge funds and real assets) where manager selection is of the highest importance. Moreover, as noted by Michael Buchanan, Deputy CIO of Western Asset Management, at the recent Crestone Investment Forum, a concerning global phenomenon is that investors in passive fixed income funds end up with the biggest exposures to the most indebted companies, and he takes the view that “active managers are uniquely positioned to outperform going forward”.

Finally, the drift away from pure active management in the equity space can take many forms, including more active (rather than purely passive) ETFs, as well as rules and factor-based investing (as noted by the Future Fund). These opportunities typically embody a fee structure that sits somewhere between purely passive and fully active mandates. Also, as the universe of passive and semi-passive investment opportunities grow, investors will increasingly need to consider which ones are appropriate for their portfolios. 

In summary

Overall, we find that the relative performance of active and passive strategies has a strong cyclical element. It is also still likely that the correct identification of successful active managers will add significant alpha to portfolio returns.

Importantly though, we believe the evolution of the active/passive debate is likely to morph over time from a mutually exclusive portfolio decision to one that combines both strategies, dependent upon the particular asset and market they are wishing to access and the characteristics that define that market—both structurally and cyclically. It will also depend on the individual investor’s particular investment style and tolerance for risk (measured in terms of absolute downside capture and relative performance to benchmark).

Looking ahead, a greater awareness of the roles that both styles can play in a portfolio and the circumstances under which one strategy is more likely to do better than the other will be increasingly critical for successful investing.

Todd Hoare (Head of Equities) and Anshula Venkataraman (Senior Funds Analyst) contributed significantly to this article. 


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Comments

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Ron P

Hi Scott. I don't understand the popular assumption that liquidity risk is higher for passive ETFs than for actively managed ETFs, let alone closed end funds. Perhaps not your view? The attached Boomberg article highlights the buffering effect of secondary markets through periods of volatility and notes the liquidity characteristics of underlying assets as key determinant in market clearing efficiency. The active manager, pursuing outperformance through more concentrated, idiosyncratic investments, surely takes on an equal, if not greater, amount of liquidity risk as a general rule? I'd be interested in your thoughts. https://www.bloomberg.com/professional/blog/active-mutual...