Active Funds – Panacea no Longer August 2014
Table of Contents Overview ................................................................................................................................................ 3 Active Fund Management in the Eye of the Storm ......................................................................... 3 Passive Investing is the New Mantra ................................................................................................ 5 Positioning for a New Landscape ...................................................................................................... 6
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Overview The Active fund management as an investment style is facing its biggest challenge. On one hand, returns are low and volatility is high, and on the other, performance against benchmarks is making even big names in the industry play catch up. There are several challenges that are unsettling active funds, with a big impact on their AUMs as is evident from quarter-to-quarter withdrawals, which are flowing to passive funds. Passive investing growth is accelerating. According to Morningstar, in the last 12 months passive investing has become the mainstream in the US, with 68% of the new money flowing into ETFs and other index tracking funds, leaving a small pie of 32% for active management. Globally, a similar trend is prevailing as the global ETF industry grew by US$28bn and US$11bn in February and March 2014, respectively, according to Deutsche Bank. Will passive funds bleed active funds dry? What investment strategy should active funds adopt to thwart the passive funds’ challenge and remain competitive as tried and tested strategies fall by the wayside.
Active Fund Management in the Eye of the Storm The Global Financial crisis had a deep impact on the entire financial services industry. Every participant had to take a hard look at its operating model and adjust for emerging scenarios to maintain profitability while containing risk to manageable levels. Figure 1 S&P 500 Returns and Risk Premium
Source: S&P Dow Jones Indices The fund management industry faced its own set of challenges. Volatility in stock prices made investors risk-averse, which was expected, but at the same time it impacted returns because of sputtering of the economic growth engines.
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Low returns coupled with higher volatility ensured that most active fund managers took refuge in index investing to protect their performance and jobs. Even when they ventured out to invest in ideas where they believed they could generate alpha, excess diversification ensured that the impact on portfolio is minimal. As index constituents (including S&P500 ) are among the most closely-observed data set and every company move is closely scrutinized and incorporated into prices at lightning speed, the market is as close to efficient as possible, leaving little maneuvering area to stock pickers. This, of course, meant that active management could generate a marginal alpha at best. With marginal alpha, it is not surprising that fund management costs would play a major role in performance benchmarks. An average SPDR S&P 500 ETF with less than 0.4% of total average costs (including fees, trading and impact costs) compares very favorably with 2%+ of total costs of an active fund. The difference gets starker as we move to the mid- and small-cap universe and then to emerging market funds. Unless active funds are making significant alpha, this difference is bound to impact returns. And it did. Almost 75% active managers significantly underperformed their benchmarks across categories. Figure 2 SPIVA 2013: Percentage of US Equity Funds Underperforming Benchmarks Fund Category
Comparison Index
Three years (%)
Five Years (%)
All Domestic Equity Funds
S&P Composite 1500
77.53
60.93
All Large-Cap Funds
S&P 500
79.95
72.72
All Mid-Cap Funds
S&P Midcap 400
74.00
77.71
All Small-Cap Funds
S&P SmallCap 600
87.32
66.77
All Multi-Cap Funds
S&P Composite 1500
80.38
71.74
Source: S&P Dow Jones Indices Only top quartile funds were able to beat the benchmark over a three- or five-year period. Even these top quartile funds had little consistency over periods, as very few top performing funds could claim to stay in the top quartile for a sustainable period of time. S&P Persistence Scorecard points to the fact that the staying rate in top quartile is to the tune of 25% over a three year period, which means that 75% of the funds that were in the top quartile in the previous period moved out to give space to other funds within a three-year period and 90% moved out in the five-year period. In simple terms, this means there is very high probability that a fund that has been a top performer today, will not be a top performer in the next 3-5 years, proving the widely-held
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adage “Past performance is not an indicator of the future!”, something that the active fund management industry tries desperately to disprove. Figure 3 Percentage of US Equity Funds that Remain in the Top Quartile after Three to Five Years
Funds remaining in top Quartile
30% 25% 20% 15% 10% 5% 0% All Domestic Funds
Large-Cap Funds
Mid-Cap Funds
Three years
Small-Cap Funds
Multi-Cap Funds
Five years
Source: S&P Dow Jones Indices With a minority of the funds beating benchmarks in a given period and almost no surety that they would beat the benchmarks consistently over the next period, rise of passive management was imminent.
Passive Investing is the New Mantra A significant rise in flow of money to passive management followed with the promise of lowcost and returns mirrored on benchmarks. Investors focused on the fact that there is a higher probability of active managers underperforming than outperforming the benchmarks and that there is no performance consistency guarantee even from those that perform in any given period of time. The threat is real, large and growing fast. ETFs now account for 25% of total funds under management in the US, 22% in the UK and 7.1% in Europe, according to Deloitte research. Vanguard Asset Management, which has built its business on the back of aggressive passive index investing, is now the second-largest asset manager in the world behind Blackrock, who incidentally also has a large passive business. Vanguard took 35% of the total fund flows in the US in 2012, a feat that it is looking at replicating in other markets. While earlier ETFs were more of an institutional play, they are now seeing a growing participation from retail. This means “standard index-plus retail funds” are no longer in vogue as it is very difficult to justify management fees and other charges in front of low-cost index ETFs.
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More and more fund houses are finding out that it is the straight way to oblivion with AUMs shrinking quarter-by-quarter. Growth is accelerating. According to Morningstar, in the last 12 months passive investing has become the mainstream in the US, with 68% of the new money flowing into ETFs and other index tracking funds, leaving a small pie of 32% for active management. Globally, a similar trend is prevailing as the global ETF industry grew by US$28bn and US$11bn in February and March 2014, respectively, according to Deutsche Bank. Whether the passive fund management stabilizes at 40% or 60% or 80% market share is difficult to guess at this moment. But one thing is certain, if the current trajectory continues, it is going to cause a seismic shift in the fund management industry.
Positioning for a New Landscape The only way for active funds to weather this storm and survive is generate sufficient alpha over their benchmarks to ensure that there is sufficient justification for higher fees and costs. If the alpha is marginal, passive funds will continue to attract higher share of incremental funds, leading to end of an era for active investing. To generate a significantly large alpha, active funds will have to transgress and focus on areas that the manager believes he can truly generate alpha in. With focus comes the vulnerability in the form of volatility in these select asset classes, leading to sharp swings in performance over a period of time. Hardly a recipe for success, unless you are Warren Buffett, and even his performance is measured against S&P500. It is not that the passive fund management is without its fallacies, however. Mirroring index means that the downside is equally large, which active management can avoid to an extent if managed well. Also, when there is bubble-like environment in some sectors, active management (at least in theory) will be able to avoid and save from the downside, albeit at the cost of shortterm underperformance. Also, there are several alternative asset classes where index investing is simply not possible because of the inherent nature of these asset classes. And to generate returns across asset classes would require active asset allocation, which the passive investing is ill-equipped to do. The premise of active investing is to identify undervalued assets and to invest in them to bring them up to their fair valuation, if all the funds are invested through passive mode, then who would play the value game? This would mean that active management is necessary for the market to remain efficient. We believe both passive and active funds would co-exist but plain-vanilla index-based active investing would really need to take a hard look at their business model and make significant changes to remain relevant.
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