In an article entitled The Dying Business of Stock Picking – published in the Wall Street Journal, Anne Tergesen and Jason Zweig make a categorical case for the ongoing demise of actively-managed equity investing.
Supported by persuasive empirical data, they convincingly argue that comparatively lower fees and superior performance have made passive investing the ‘default option’ for many investors, driving billions of assets into passive mutual funds and exchange-traded funds (ETFs) in what can be seen as one of the largest migrations of money in history.
Their claim regarding the differential in fees is the clearest and most compelling of arguments. According to data compiled by Morningstar, the average annual fee for US domestic equities mutual funds was nearly 0.80% for actively-managed funds, vs. 0.10% for their passive counterparts. Increasingly, investors recognize that such a large variance in fees can only be justified if actively-managed funds can deliver superior long-term risk-adjusted returns. Yet, data shows that over time periods ranging from 1- to 25-years, the vast majority of mutual funds underperform their respective benchmarks.
What can possibly explain this alarming statistic? The main culprit is most definitely high management fees themselves, which directly eat into investors’ returns:
- the higher the level of fees, the higher the hurdle to beat the benchmark.
- investment managers that fail to be disciplined and patient in applying a clear investment philosophy and process, instead opting for the relatively easy path of so-called ‘closet indexing’ characterized by a low active share, have little chance of outperforming passive funds in the long-run. As such, a portion of active investment managers have only themselves to blame for their competitive failure, by being overly commercially-minded and failing to create the necessary conditions to deliver adequate performance after fees to their clients.
In a world where generalizations and caricatures are too often commonplace, it is important not to think about active vs. passive investing debate in an overly simplistic way. Below, we list a number of observations that suggest this debate is a lot more nuanced than some would argue:
- One must realize that active and passive investing do not exist in isolation from one another. Passive investing, which predominantly employs a market capitalization-weighted or float-weighted fund construction methodology, commits capital independently of underlying business fundamentals, valuation, and investment risks. But, as First Eagle Investment Management right asserts, ‘this strategy of willful ignorance, albeit low in cost, works well only if there is a vibrant active investment management industry that is pricing the underlying securities relatively efficiently through competitive processes.’ In short, passive investing requires efficient markets in order to properly function, yet it itself doesn’t contribute to this imperative; rather, it arguably hinders it.
- many investors may currently feel a false sense of security from being invested passively, as the past 9 years have seen a steady upwards trajectory in equity prices – largely due to the accommodative policies of central banks worldwide – which has yielded good investment results to them. But given the current investment landscape, characterized by high valuation levels and significant risks, it is reasonable to assume that stock market returns should be muted over the next 10 years. Can actively-managed equity strategies outperform their passive counterparts in such an environment? We think some of them can.
- While the market as a whole may be priced for low returns going forward, not every individual security is trading at an all-time high. In fact, around the world and across sectors, many companies have gone through their own idiosyncratic ‘bear market’. In this context, stock selection can be a powerful driver for outperformance going forward, especially if performed diligently and by committing capital at a suitable margin of safety. Similarly, holding cash when the availability of stocks trading at attractive valuations is scarce is quite unusual in the industry. Yet, cash should be seen as deferred purchasing power – which, if deployed counter-cyclically, can be a formidable source of outperformance.
The debate on active vs. passive investing isn’t as ‘black and white’ as some would argue. On the one hand, we should all welcome the advent of passive investing, which has provided investors with a way to gain exposure to the wider equity market at a very low cost. It has also prompted the active management industry to take steps to improve performance and lower fees, a competitive rivalry that is ultimately in the best interest of investors. On the other hand, many of the risks related to passive investing – such as those related to liquidity – are seldom talked about, and investors would be wise not to extrapolate the recent past in thinking that passive is the best method to invest in all market environments.
We believe that both active and passive will continue to co-exist, with assets flowing from one camp to the other in long-term cycles, as it has in the past.