Over the last decade there has been a tremendous flow of money into passive investment products. Data from Morningstar indicates that index funds now hold close to 50% of the US stock market.
This move has been caused by a number of factors, but essentially it is a question of value. The higher fees charged by active managers and their inability to consistently beat a market benchmark have led investors to question exactly what they are getting for the amount they are paying.
“The industry has a crisis of legitimacy,” Mark Ferguson, chief investment officer at Generation Investment Management told the MSCI Global Investing Conference in London last week. “Everyone has worked out what they are selling – namely alpha – that, mathematically, they can’t generate.”
Yet there has been no broad-based move to position active management in a more sensible way, even though there’s an obvious way for it to do so.
The clear opportunity
“Why are we trying to define ourselves on this basis, and passives are eating our lunch, while the planet is going to hell in a hand-basket?” said Ferguson. “There’s an obvious opportunity to redefine the purpose of active management around a whole number of subjects including climate change, active capital allocation and stewardship, but we see it as a sidebar issue. It’s a complete failure of the imagination. The industry needs to start thinking about this as [a] core issue to protect itself and its legitimacy long term.”
Active managers have the ability to be forward-looking, and to make qualitative and not just quantitative judgements. This is a material advantage in a world where the risks and opportunities presented by the transformation of the economy that is demanded by the climate crisis are largely impossible to measure.
“The new economy will emerge in two different ways,” said Catherine Howarth, chief executive of ShareAction. “There will be disruptive new firms, such as Uber and Tesla, and then there will be old industries and incumbents that transition and have within them the adaptability to innovate and move.”
How these transitions play out will radically change how stock markets look.
“I don’t think it’s going to be an entirely new set of companies, but it will be a set of companies that looks very different,” said Howarth. “From an investment point of view that creates real opportunities for active managers because there is huge uncertainty and huge risk. Smart active managers that can see the real opportunity set have the chance to navigate that.”
While index providers and passive fund managers have done a lot to introduce products that mitigate against climate risks, they have to rely on backward-looking metrics.
“In a world in which we are truly transforming the economy there are serious opportunities for active managers who can be forward-looking, over passive funds that are tracking an index,” Howarth said.
She does still see passive funds playing a role, particularly as more of them use their substantial voting power to influence company behaviour. However, the active industry has a meaningful advantage if it chooses to exploit it.
“It’s not that passive is going to go away,” said Howarth. “It will have a really important function. But the ability of active managers to allocate capital into new industries, and to pick winners, which is what they are supposed to do, is a real opportunity.”
The big win-lose
This does, however, require genuine courage and conviction.
“I hear people say that once the policy moves that’s when the big money will be made, and that’s when we’ll move more actively,” said Ferguson. “But I can’t think of any issue in the history of active management where there have been any returns made by waiting for the politicians to tell you what to do. In his particular case it’s an unpriced risk, and waiting for policy approval will be a big mistake. You will lose return upside and probably take pain from risk you can’t properly price.”
There is also, Ferguson argued, no scenario in which the current order continues, just with minor changes.
“If you’re looking at your portfolio – leaving aside fossil fuels that are obvious – don’t think there is going to be a grand settlement, where anyone who is kind of a good guy, who is kind of doing enough and working really hard, but not really getting anywhere, is going to be given a pass,” he said. “There is going to be point of retribution.
“If the business model you are accessing in any industry doe not have a path to make money at zero carbon or a massive price on carbon they will be taxed, because we will need that money to pay for all things we should be doing that we will suddenly realise we have to do,” Ferguson added.
The impact this will have on investments will be dramatic, and active managers should see their ability to navigate this risk as their primary value proposition.
“This will not be a win-win,” Ferguson said. “It will be a win-lose. You will have to work out does my investment portfolio represent a collection of winners, or does it represent a collection of losers, and what am I going to do about it?”