The active versus passive debate has rumbled on for many years – with assets under management steadily flowing to the latter – but since the turn of the year a raft active managers have reconfigured their business models to reflect the shift in investor appetite.
The market has bifurcated to avoid the dreaded middle ground of index-hugging. Reports by the European Securities Markets Authority, which estimated last year that between 5% and 15% of managers charged active fees for largely replicating an index, and the UK’s Financial Conduct Authority have further pushed demand for low-cost passive products or high conviction portfolios.
In late March the world’s largest asset manager BlackRock announced it was revamping its active equities group and shifting billions of dollars run by traditional stock pickers into quantitative strategies, in a move seen as a response to client demand for index-tracking exchange-traded funds (ETFs).
When the switch was announced, the company’s global head of active equities referred to fee compression driven by competition with ETFs and regulatory pressure on the active equity model.
The shift in demand was overwhelming; 2016 figures showed that BlackRock experienced significant outflows from its active equity funds and received record new money into its ETF business.
Less than a week after the Blackrock announcement, Fidelity International announced the launch of two income-focused smart beta ETFs – Fidelity Global Quality Income Ucits ETF and Fidelity US Quality Income Ucits ETF.
It said the funds – the first of their kind for the company – would provide exposure to high quality companies that pay attractive dividends, based on the premise that companies with stable earnings and cash flows outperform over time.
Nick King, head of ETFs at Fidelity International, expects that demand for smart beta strategies will continue to accelerate with investors continuing to favour low-cost products but ones that offer differentiation from their peers.
Also in April, Aberdeen Asset Management’s global head of distribution revealed that the new business – that would emerge following the planned merger with Standard Life – intends to build a smart beta offering.
While he reaffirmed the company will remain committed to active management – hardly surprising given its historical commitment and company culture – he added that it will also monitor the market for mutual fund ETFs.
Smart beta pioneer Rob Arnott, founder and chairman of Research Affiliates, sounded a cautionary note recently, however, taking issue with two assumptions that form the basis for how many investors view factor alpha and smart beta strategy alpha.
He says that many wrongly suppose that past performance is the best prediction of the future performance of a factor tilt or smart beta strategy and that the tilt or strategy has a constant risk premium (the return above the risk-free rate) over time.
The opposite approach to joining passive managers is, of course, to take an increasingly high conviction approach – rather than competing on cost managers move further away from the replicable benchmarks and seek to add more alpha.
Active share has become the established metric – benefiting from being easily understood – for investors to substantiate whether they are actually receiving the active management for which they are paying.
However, several managers interviewed for this article cautioned that the measure can be misleading in isolation, pointing out that it should not be assumed that a fund will outperform just because it has a high active share – it merely rules out the possibility of benchmark hugging.
A high active share figure means that performance is very likely to differ from the market, but that could be negative, even if other funds with similar active share outperform. Among the giant global asset managers Fidelity has perhaps been the most critical of the use of active share as a guide to pick funds.
According to Ben Peters, co-manager of the Evenlode Income Fund (which has high active share of 80.2%) it is crucial that this observation is followed up with deeper questioning.
He says: “From the manager’s perspective, they need to be able to communicate how their portfolio differs from the market, the process that leads to the inclusion or exclusion of stocks – or indeed whole segments of the market – and whether the process sounds sensible given the manager’s aims.”
The answers to these questions – combined with the knowledge that the manager is indeed being active – will provide investors with a sound basis for anticipating decent long-term outcomes.
“In the shorter term, if a manager is truly active they will almost certainly go through periods of underperformance,” adds Peters. “A sensible process will help the manager and their investors see through these less positive periods, which is critical if outperformance is to be achieved over the long run.”
Dan Brocklebank, head of Orbis Investments UK, says the firm has always known that it cannot expect to deliver superior performance if it is doing the same thing as everyone else. The result is a fundamental, long term, contrarian investment philosophy that aims to identify the relatively small number of companies that it considers to have meaningfully undervalued share prices.
But he agrees that active share still doesn’t tell the whole story. “In addition to knowing how active a manager is, it is important for investors to understand the manager’s philosophy, process, ownership structure and incentives. The key question to consider is whether an active manager is truly offering something different (and better) than a low-cost tracker fund.”
Indeed, new study by Fund Consultants that revealed that ETFs do not necessarily outperform active investment trusts, net of fees. The research found that in all four of the studied categories investment trusts outperformed ETFs over certain time periods, most notably over the medium to long term in the equity and aggressive allocation categories.
BEYOND ACTIVE SHARE
While this is not something that any manager can guarantee in advance, the approach Orbis has taken is to offer its clients a refundable performance fee structure and invest its own money alongside that of its clients.
“This not only ensures that we have a strong incentive to invest differently, but also that we feel our share of the pain when we underperform,” adds Brocklebank.
Last year Morningstar studied a subset of European funds investing in European equities to see how their active share had developed from January 2005 to June 2015. The report found that funds with higher active shares received the lion’s share of new assets and delivered better investment results than the least active funds across most of the research period.
However, the authors also warned that because dispersions in returns and risk characteristics become much wider as a portfolio’s active share rises towards 100%, investors should not rely solely on active share when selecting funds.
While some active managers have embraced ETFs enthusiastically as investment tools in their funds this is not necessarily the best approach.
But Ben Kumar, investment manager at 7IM says that while the firm continues to use ETFs as a liquid way of accessing gold, it has reduced its overall use over the last few years.
“For example, five years ago 35% of our AAP Balanced Fund was in ETFs compared to 15% today,” he says. “In essence, there are cheaper and more flexible options out there, such as futures contracts and
Copley Fund Research founder, Steven Holden, suggests more information needs to be made available to investors and is critical of the quality of the ratings made available by the fund information providers.
“All too often I see three or four star ratings for funds that closet-track the index, particularly in the US where the benchmark has performed so well. Anyone tracking it has also performed well and hence receives a good rating,” he says.
This view is shared by James Budden, director of retail marketing & distribution at Baillie Gifford, who says there is documented evidence to show that active managers with low turnover indicative of a long-term approach, high active share and engage positively with companies they invest in outperform net of fees.
“It follows that active managers should illustrate that they meet such criteria if they want to be seen as different from the index-huggers and traders,” he says.
Holden also says that many investors who have access to active share are not using it correctly. “In some cases they believe that the higher the active share the better,” he concludes. “In reality, once a fund is above 75% active share it matters little if it is 76%, 85% or 95%.”