Over the past 10 to 15 years, the global shift into passive or rule-based investment products has been remarkable. In May this year, the assets held in passive funds in the US surpassed those invested in active portfolios for the first time.
According to the Boston Consulting Group, traditional active core mandates accounted for 57% of the assets under management in the global industry in 2002. That had declined to 33% by 2017, and is expected to fall further. Over the same time, rules-based strategies grew from 9% of the assets under management in the industry to 20%, and are expected to continue to gain.
In South Africa, it is noteworthy that the growth in the number of active unit trusts over the past few years has been well below that of passive funds.
This shift has been extremely important for investors because it has introduced a new level of competition that didn’t exist before.
The big challenge
“The change in dynamic between active and passive is the dominant theme in asset management,” says Gary Baker, MD for Europe, the Middle East and Africa at the CFA Institute. “It is a big challenge for an industry that has been built on quite a lot of specialisation, and specific knowledge of markets and products.”
The area where it has had the most obvious impact is fees. According to the latest Nedgroup Investments Core Chartbook, the average, asset weighted total expense ratio (TER) across the industry in South Africa has fallen from 1.26% in 2013 to 0.96% in 2018.
A large part of this is due to active managers being unable to collect the same level of performance fees they have in the past due to the depressed market. But the pressure on managers to lower their fees is obvious as even passive managers have reduced their TERs over this period.
The impact on active managers has, however, gone well beyond this fee pressure. It has become something of an existential issue. This is because the success of index investing has undermined their value proposition.
What are asset managers selling?
“The idea that you can sell the concept of just beating an index paints you into a very narrow corner,” Baker says. “Just simple mathematics suggests that not everyone can beat an index.”
The problem is that if beating an index is the definition of success, then a large proportion of active managers are doomed to fail. This is a conundrum that the industry has created for itself, because if outperforming an index is what asset managers are selling, their value proposition is not particularly attractive. It is also, on reflection, not really what investors need.
“What investors are more bothered about is how does a product get me to my life goals – how does it help me to save for retirement, or educating my kids, or buying a house,” says Baker.
“The industry has gone down this marketing route of being index beaters rather than providing solutions for real-life events, which actually gets to the essence of what finance is trying to do.”
He believes this will continue to cost the industry unless it adjusts its message.
“If we talk about providing solutions, it becomes a more honest and more authentic message, and one that will resonate with investors. At the moment, I think the industry is reaping very much what it sowed – introducing jargon that has not helped its relationship with the end investor at all.”
Adding real value
The future for the industry may therefore need to look quite different to the past. In particular, there are three areas where active managers can really add value, and this is where they should perhaps be focusing more attention.
The first is private equity.
“I think we miss something in only focusing on public markets,” says Baker. “If you broaden the lens to include private markets – that requires very active management. And what is the skill set required to analyse private market investments? It is very similar to those that asset managers already have in public markets.”
Secondly, the rapid shift to incorporating environmental, social and governance (ESG) factors in investing is one that inherently favours active managers.
“In some ways passive strategies rely on a degree of efficiency in markets and information flow,” says Baker. “That is not always available when it comes to ESG. It is an area where, often, value judgement is needed, and so this should be an area where managers can add value.”
Finally, there is a significant opportunity in changing technologies, and finding the synergies where humans and computers working together can deliver superior outcomes for investors.
“The biggest opportunity for active management I have seen in at least the last 10 years is the explosion of available data and the technology to access it,” says Ron Kahn, global head of scientific equity research at BlackRock.
“There’s just so much more data available now, and it does require different skills to analyse,” he adds.
“I feel the sweet spot is if you can combine people with an understanding of finance, economics and accounting, with people who understand big data and machine learning. It’s easy to look at all the things that are negative for active managers, but if you want to find one thing that is a really big opportunity, I think this is it.”