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The division between active and passive strategies has devolved into a two-legged stool. A stronger investment environment needs a clear third option: the enhanced passive category.
There has been a relentless increase in passively managed funds and the emergence of strategies that are very different than traditional index-tracking portfolios, but classified under the passive label. The time has come to support and highlight those investment approaches by assigning them a distinct third strategy type.
Enhanced passive includes most smart beta and factor-investing funds, including ESG and SRI strategies that are not actively managed through individual stock selection. Despite the interest in those strategies, they have gotten lost, without a clear category. For example, they suffer from being called a “so-called smart beta fund.” But enhanced passive is a much clearer category from which to start educating and warming up what is already the next big innovation in investing.
Many arguments have been made on the merits of an active (a human portfolio manager making buy, hold and sell decisions) versus passive (investments that track and index) approach to portfolio investment decisions. Passive management comes with lower turnover, fewer costs and generally reduced fees.
Active managers often leverage factor analysis and models to support the screening, selection and timing of trades. Both the DJIA and the S&P 500 have committees that ultimately make the decisions on index composition. Model, as manager, is a different approach from passive and active management. Enhanced passive occupies the space between the two and reflects the most promising academic research, which investors can access and assess on its merits. That research is applied in an automated model to identify positions and make adjustments within a fund.
The warning signs for passive investing
Industry participants, sometimes with a bit of glee, have predicted that passive investors will learn the hard way in the next market correction that losses will be much larger than in actively managed portfolios.
There are many products labeled as passive that would fall within the enhanced passive category and are designed to reduce the risk of downside losses. Predictions have been made that investors will pull out of passive more quickly than active funds in market downturns and make the market more volatile. In the short-lived Q4 2018 U.S. equity swoon, more AUM left active than passive. According to Morningstar, active U.S. equity funds in December of 2018 had $31.5 billion in outflows versus $45.6 billion in passive inflows. The S&P 500 fell over 9% in the December after falling almost 7% in October.
The Federal Reserve Bank of Boston published a paper on August 27, 2018, The Shift from Active to Passive Investing: Potential Risks to Financial Stability? One of its conclusions was that passive investors are less reactive to performance than active investors. One explanation is that passive investors believe they are exposed to less risk. Higher fees on active funds have had a negative impact on their long-term performance. Transparency and competition has been compacting the fee gap between active and passive; the expanding passive label no longer always equates to less expensive.
If everybody indexed…
Investors have been bombarded with statistics on how most active managers underperform their index. For the last nine years, the majority of U.S large-cap funds have underperformed. Among active large-cap managers, 64.9% have performed below the S&P 500 in 2018 (according to the S&P Dow Jones SPIVA report).
“If everybody indexed, the only word you could use is chaos, catastrophe. The markets would fail.” Most will remember this statement made by the late John Bogle, founder of Vanguard, who has been at the forefront of indexing. Bogle was speaking at the Berkshire Hathaway shareholder meeting in 2017. He was warning that there is a limit to the amount of passive investing a market can handle. We can surmise that he did not want his legacy connected to too high a concentration by a few large, passive asset managers. One adverse impact would be outsized control over corporate governance.
The Boston Fed study mentioned above looked at that risk and a number of others. But most of the risks it studied have yet to materialize and in several cases the opposite impact has been observed.
Resistance is not new
There is always resistance and skepticism associated with big shifts in how things are done. The evolution of passive investing started very slowly in the early 1970s, with Vanguard reaping both credit and assets. Enhanced passive is not yet in the mainstream where investors can be best informed. Formal recognition and distinction is necessary.
Funds that go beyond capturing market beta without a portfolio manager have defined this evolution as enhanced passive. The investing public needs statistics about those approaches. Institutional and wealth management portfolios are increasing their allocation to enhanced passive strategies.
Competition among asset managers as they create new enhanced passive products has been fierce, fostering healthy innovation. Passive investing Millennial Investors in particular have shown lots of interest in enhanced passive funds, which offer ESG and SRI disciplines.
Elevating the active-passive discussion to include enhanced passive will create a more rewarding discourse and investors will be well served as they increase their understanding, confidence and allocations to those strategies.
David Merrill, Partner TechCXO, Providing strategy and execution consulting to analytics and data providers, wealth and asset management firms and the vendors who support them. [email protected]
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