“Nobody comes here anymore, its too crowded.” – Yogi Berra
It’s been over a year, so here is another weekly edition of Blogger Wisdom. As we have done in previous years we asked an esteemed group of finance bloggers a series of (hopefully) provocative questions. Their answers are unedited and the author’s name, blog name and Twitter handles follow. We hope you find something of interest below.
Question: Traditional active management is dying a slow, painful death. Is the introduction of non-transparent, active ETFs a potential turning point or simply a finger in the dike of an unstoppable trend? (Answers are in alphabetical order.)
I figure asset management companies will try every marketing tactic under the sun in an attempt to stimulate flows back into active management. You’re going to see a lot more actively managed ETFs or “smart beta” products over the few next years. You’re already seeing this today. However, all roads lead to the inevitable no matter how good the story.
I think you said it perfectly. A slow painful death. This death will in my estimation continue for the rest of our careers. Active management outflows are probably permanent, but there are so many dollars there that it will take decades for this to run its course. And I think that eventually the gushing of outflows will slowdown and it will arrive at a steady state. I have no opinion on when or how that happens.
I don’t think this will be a big factor in changing the active/passive dynamic. Having a structure that is a bit more friendly in terms of tax consequences is a positive at the margin, but that’s not enough. The expense differential and the historic underperformance will continue to weigh down active management in general. That said, I do think that value can be added by active management, but it requires rethinking the standard approach. The leaders of most firms are reluctant to take the steps needed because the historical business model has been so attractive. They keep waiting for an inflection point back to the good old days – which won’t come around again unless they make changes.
I don’t believe the death of active management is secular. I think it’s cyclical. And it has to do with the unusually strong recent performance of the US stock market, which can be bought for basis points. Any deviation from US stocks, through diversification, risk management or hedging has led managers to underperform US indices. That’s unusual. The usual case is there is a benefit to diversifying, particularly into robust factors like value, momentum and trend or global stocks. High fee, haphazard, index-hugging, pseudo-“active” funds will slowly go away. But funds with a large active share that offer concentrated exposure to strategies that difficult to implement are here to stay.
My vote is finger in the dike of an unstoppable trend…although I think active management’s long slow death still has many years left. There will always be investors who will look to beat the market. This new lower cost actively managed ETF will be trendy and have a good story behind it, and I think retail investors and brokers will be drawn to it, but the financial planning community may pass. As a financial advisor who believes the profession will continue to move toward a focus on planning, behavioral counseling, and less focus on beating the market, I don’t see a large adoption of a non-transparent active ETF by advisors…unless, performance make a compelling case for them.
Money managers are always introducing new products that enjoy momentary buzz. But the buzz never lasts, because these money managers can’t repeal the laws of mathematics. Before costs, investors collectively earn the results of the market averages. After costs, they inevitably earn less. Matching the market while incurring minimal investment costs–which is what index fund investors do–will always win out. Active ETFs are just another sideshow that’ll be far more lucrative for the money managers involved than for the gullible investors who pony up their hard-earned dollars.
This is just a rebranding of mutual funds. It’s like calling a Patagonian toothfish a Chilean sea bass.
And I disagree that active management is dying. It’s just changing. Active managers can’t hide behind beta or momentum or whatever factor you like and pretend it is alpha. That is a good thing. Heck, it’s a great thing. Chasing returns from factor bets should cost very little, and if alpha remains thereafter, there will be those active investors that capture it (and charge for it), and those that surrender it (and pay). That is just Bill Sharpe math.
And while behavioral mistakes may be executed by humans, so is the coding. And even if the coding is done objectively, and without bias, we have to consider what the systematic investor is trying to expose or capture. It might be something caused by a human behavioral bias in the first place. Moreover, sure the collective actions of systematic investors may potentially eliminate the bias, but it isn’t impossible that those collective actions may just exacerbate the price action related to the bias.
And as long as there is bias, there is alpha.
The majority of traditional active managers were nothing more than closet-indexers with high fees. That game is over. Active managers who take real active risk and have a consistent, repeatable process, will find investors when the dust settles. But the real trend is towards lower cost investing. Only companies that can be profitable with lower fees will survive. This probably means there will be more consolidation in the industry. It will be very difficult for new managers to get started.
This is a really interesting development. A lot of active fund underperformance is down to fees, so if the fees for active management start to look more like the fees for passive then we might start to see some cream rising to the top. That said, you’re still left with the issue that it’s almost impossible to differentiate between luck and skill, so even if an active fund outperforms (whether it’s cheap or expensive) you still have that to deal with. I think the march towards passive will continue – there’s still a huge argument for being certain of getting the market return rather than the possibility of beating the market.
Similar to the “is value dead?” discussion, I think calls for the death of active management are premature, too. A more likely possibility is that active management is simply adjusting and transforming to cater to a different generation of investors. The current cycle has been exceptionally supportive of passive strategies. That will also end at some point.
I believe the poison that been slowly killing active management is Vanguard’s mutual share structure.
It is simple arithmetic to demonstrate that the portfolio of any active manager can be decomposed into two pieces: their benchmark and a dollar-neutral long/short portfolio that captures their active bets. The fee investors pay covers both the cost of beta and the cost of the active bets.
As Vanguard’s mutual share structure drove the cost of beta towards zero, a higher proportion of an investor’s fee became associated with the active bets. This implies a higher hurdle rate that managers must overcome before an investor sees any value.
As a simple example, consider a mutual fund charging a 1% fee for a large-cap equity portfolio. If the manager has a 25% active share, and we assume a 0% fee for the benchmark, the implied hurdle rate is 4%! In other words, the manager has to generate more than 4% alpha before the investor benefits.
If we track fund fees over time, we see that active managers did not make commensurate fee cuts with passive beta until far too late. I would argue, however, that this is where systematic portfolios and so-called “smart beta” products established their beachhead: being able to offer a transparent and consistent active process for highly competitive fees.
For traditional, discretionary active managers to remain relevant, I believe they either need to significantly cut costs or take on significantly more tracking error (and career risk). Non-transparent, active ETFs are not going to fix this problem.
Active will never die, because the rewards for being right are so big that it makes sense to try just in case. But I’ve always thought the move away from active was actually just a move away from high fees. Moving to non-transparent funds seems like a similar problem, because he underlying cause of the move away from active is that investors — particularly the new generation — have a much lower tolerance for bullshit than previous generations.
I don’t think the structure itself represents any sort of turning point for traditional active management. People haven’t been leaving active equity funds in droves because they can’t trade their mutual funds intraday. The tax efficiencies gained from the new structure are a plus, but I don’t think that moves the needle enough. The evidence against active has been pretty damning even before taking taxes into account. Now, if this structure can be paired with much more reasonable fees and truly active, non-closet indexing approaches to discretionary stock picking then maybe – just maybe – there’s a chance. But I won’t hold my breath. And even if the odds for active improved, that still doesn’t make any of us likelier to identify the winners in advance.
Any investment strategy relying on humans predicting the future via security selection or marketing timing is destined to die.
Active and passive management has historically been cyclical, going in and out of favor based upon several factors – not the least of which is recency bias. That bolsters the argument that with passive management in such favor now, the pendulum will eventually swing back toward active.
Today though, the capital flows into passive management funds are driven by underlying structural changes instead of traditional factors. That means this trend can go on for a very long time. However, the trader in me – knowing everybody can’t be on one side of a trade – tells me this trend can’t last forever.
It’s an unstoppable trend for lots of areas of the market (i.e. large cap US equity) and I don’t think “non-transparency” will save this. I am not opposed to non-transparency, but I don’t think the issue here is copy catting, but lots of people abandoning high fee for low fee products.
The non-transparent active ETFs are noise, like closed-end funds. Active management is not dying, it is a bear market away from proving its worth, as it always does. The ability to correct for changes in valuations, and avoid fads is valuable, and will become more so if indexing gets larger still.
I think the problem with traditional active management is that ETFs and quant are replicating what they do in a far cheaper and more tax efficient way. My guess is that traditional active management will be around for a long time as it seems in every field that has undergone a quant revolution (i.e., chess, diagnostic medicine, etc.) that humans + computer is better than either individually. Once the active management industry shrinks and re-tools to be a compliment to a more quant process that active management will thrive again.
This question includes an assumption. I understand the recent ETF trends. As an active manager and a member of the National Association of Active Managers, I see a lot of value-added strategies. There are many effective approaches and I encourage respect for those who have different ideas.
I don’t think non-transparent ETFs will work in the long run. Meanwhile, I am amazed that investor flood into non-traded REITs and BDCs just because they claim a high payout.
I think the non-transparent, active ETF structure is interesting because it eliminates one big drawback of active mutual funds – tax inefficiency. However, it will be interesting to see how these products are priced relative to passive and factor ETFs. My guess is that if the mutual fund shops filing for non-transparent, active ETFs are still planning to charge significantly more than passive and factor ETFs, they will have a hard time gathering assets. As many others have previously stated, the active-passive shift is more about high cost vs. low cost than anything else.
All RIAs are active managers even if they buy and hold indexed products. Portfolio decisions are often made based on client need (client paying for a child’s wedding as a good surprise or paying for a new roof as a negative surprise) and a decision must be made about how to take money out. Active management sold as alpha everyday all day has very little practical appeal for how difficult/impossible it is to do but that doesn’t invalidate active management. Clients might have a low tolerance for volatility to manage around or a concentrated position in company stock to manage around. I generally maintain a mix of individual issues and indexed products in pursuit of decent upside capture while trying to avoid the full brunt of large declines (hundreds of articles at my blog on this). An ordinary investor will have years they outperform their benchmarks and years they lag and clients can understand that.
Who knows, but we will always distinguish between price and value. If you can deliver something of value, you’ll be good. The challenge in asset management is that the terrain for adding value has shrunk so considerably.
History is repeating itself. Whenever there’s a ground-breaking product innovation, the investing industry will produce its own, inferior version and slap a higher price tag on it. It happened with the invention of the mutual fund, then the index fund, and now the ETF. Don’t write off active management, though. Human nature combined with slick PR and marketing will ensure it always has a place.
Neither. My guess is that active management will morph into (a) highly active, concentrated investment strategies (high active share); and (b) highly personalized active management with individualized value judgments combining with investment judgments on potential holdings.
Not all investment can be passive. You need active traders to make price discovery possible, and passive investing only works because active traders force the market into a state of efficiency. But the move to passive indexing has a lot of momentum right now and doesn’t look to be slowing down. It’s too early to say exactly how this shakes out, but I would imagine it will go something like this. The market will hit a tipping point at which “too much” money is passively invested and not enough is active. This will cause market returns to be lower than in the past but will also create the conditions that will make good active investing profitable again. It may never again be as lucrative for Wall Street, of course. But that’s not necessarily a bad thing.
I don’t think active management is dying a slow death, it’s that vary belief that makes me think we’re rounding out a bottom in active management. Just like other segments of investing, styles have ebb and flow of sentiment and there’s no doubt the sentiment towards the style of active investment management is in the dumps. This creates the opportunity for truly skill managers to have a phoenix-like rising when the tide does eventually turn.
Thanks to all the bloggers for their time and effort. Stay tuned for a new Blogger Wisdom question tomorrow.