The renaissance of active management
Active management is evolving and could be about to experience a renaissance as we transition into the next phase of the cycle.
Passive investment strategies have enjoyed tremendous growth over the past decade, thanks to stellar market performance and increasingly competitive fees, and today account for around 45% of investors’ asset allocation in the US1. In contrast, only a minority of active managers have outperformed after fees over the past ten years, according to SPIVA. However, trends in performance of active versus passive strategies have historically been cyclical. Active performance was strong compared to passive strategies from 2000 to 2009, for example. We believe active management is evolving and could be about to experience a renaissance as we transition into the next phase of the cycle.
Since the Global Financial Crisis, market conditions have been highly favourable for passive strategies, as central bank easing helped drive a strong and prolonged rally in risky assets, which has seen asset prices decouple from fundamentals. We have been in an environment where returns attract flows and flows drive returns: in other words, momentum has been the main driver of market performance. This has been especially beneficial for market cap-weighted passive strategies, which by design maximise exposure to past winners. In an environment of low interest rates and high valuations for traditional assets, downside risks are mounting. Passive strategies, which make no provision for risk allocation, are more vulnerable to sharp corrections in overvalued and overcrowded trades. Active managers, with their focus on fundamentals and their ability to dynamically manage risk, are much better placed to ensure downside resilience and deliver returns in volatile markets. Indeed, as the risk-on rally began to falter in 2018, the number of active managers beating their benchmarks after fees improved.
The value proposition of active management
The value proposition of passive management is very simple as its outcome is to replicate an index. Active management has a more complex value proposition. The first part of this proposition aims at delivering outperformance versus an index. However, one cannot narrow the proposition only to that. Active management permits to have better active risk management versus an index, in a way that is more closely aligned with investors’ risk appetite, goals and constraints. However, achieving those objectives is less predictable, being largely dependent on manager skill and process.
A new style of active management
Active management is evolving, thanks in part to developments in factor investing and ETFs, which have provided investors with access to specific asset classes or market segments via a single security. As a result, there has been a shift in demand from bottom up to top-down active management, using passive strategies as building blocks to capture the desired exposures. The era of passive balanced multi-asset management is ending as investors increasingly recognise the value of a dynamic approach that can adapt portfolio allocation to different market conditions. We are also seeing a gradual redefinition of the role of asset classes, as active managers find alternative ways to replicate the historic risk-return characteristics of traditional assets. With bonds offering much lower yields and hedging potential than in the past, the need for new sources of return and diversification is driving the development of innovative alternative risk premia strategies. Investors are also increasingly allocating to private equity over listed equities to gain a broader exposure to the economy, as the public market continues to shrink, and companies are remaining private for longer. Finally, there is growing demand for more concentrated, capacity-constrained active strategies, which are perceived as being able to deliver more robust idiosyncratic returns.
New technologies bring new opportunities
Asset management is a domain where you benefit not just from being smart…but from being smart in a different way to others. Embracing new technologies will be one way for active managers to outsmart passive ones. There is huge potential for asset managers to use machine learning and AI to support their investment decision-making and deliver better outcomes to investors, especially if backed up by human experience. With machine learning comes big data, since for machines to learn, they need to feed on a massive amount of data.Grinold’s fundamental law of active management tells us that achieving high risk-adjusted returns is a function of three things: skill, the number of independent investment decisions taken, and the translation of these insights into portfolio implementation. If alpha is generated by skilfully exploiting information, the enormous rise in the volume of data available presents opportunities for active managers to transform their research into new sources of return.
Active management has a societal role to play
Following the secular trend towards a more purposeful capitalism, there is a growing recognition that asset managers can play a wider role in society through the investments they make. This is particularly true of active managers, who can allocate capital responsibly to finance growth in a sustainable way. Furthermore, although passive managers have helped lower the cost of investing, active managers, through research and price discovery, are key to determining the fair value of investments.
Necessity is the mother of creativity
Exponential growth in the number of market players, including algorithmic strategies, has degraded the pool of alpha available, meaning that some consolidation is likely and only those who can demonstrate real added value will thrive.
Growth in passive investing has created both challenges and opportunities for active managers. Market conditions are likely to become more favourable for the latter as we enter the next phase of the cycle, with a renewed focus on fundamentals and risk management. Nonetheless, it will remain essential for active managers to embrace change and adapt to investors’ evolving needs in order to deliver more sustainable and repeatable outcomes in the future.
(1) Bank of America Merrill Lynch - www.cnbc.com/2019/03/19/ passive-investing-now-controls-nearly-half-the-us-stock-market.html
Fiona Frick has been the Group CEO of Unigestion since 2011. She started her career at the company in 1990 as a fundamental analyst, covering traditional asset classes, before becoming an investment manager for bond funds. In 1995, she led the