A recent article in the Financial Times, by John Authers, has highlighted some key developments in the passive/active fund management debate. The article discusses the apparent contradiction that growth in the use of passive products, internationally, has stimulated the demand for active asset managers. One person Authers interviewed put the following perspective forward: “(w)hat I want to know is, how do active managers even exist? Everyone has known for years that they don’t earn their money. And yet there are even more of them.” The key to understanding this apparent conundrum lies in the fact that active managers, those who have ‘come out of the closet’ (in other words are truly active, not closet index huggers), are profiting from growth in the use of passive investment products.
Authers references the concept of active share in his article. This is a term for a measure of the extent to which active managers’ portfolios actually differ from their benchmarks. Somewhat counter-intuitively, it is reported on a scale of 0–100, where a score of a 100 reflects a portfolio that is exactly the same as the index (i.e. no active share at all) and a score of zero reflects a portfolio that is completely different to the index (i.e. an active share of 100%). Be that as it may, this tool gives investors and their advisors an opportunity to measure the extent to which their managers’ portfolios are closet index trackers and those which are truly active.
There is one good reason for being an index-hugger, as it’s a low risk business strategy; you are never going to significantly underperform the index if you don’t vary from it and therefore you potentially have a lower chance of losing your clients.
Unfortunately for those managers, the growth in the use of passive products is putting the spotlight on the degree of ‘activeness’ of the active managers. Many have turned out to be still in the closet – i.e. not very active at all.
Those active managers that are still ‘in the closet’, are going to be the ones that may be the biggest losers to cheap, passive, index replicating products. The winners are going to be those active managers that are able to provide a different solution to the index; vitally, these differences must generate outperformance. Other research suggests that this is possible.
From our perspective, this supports the MitonOptimal view that passive and active managers are complementary – in that it is not an either/or decision. What it also highlights is that your active managers must truly be active – it’s time for them to ‘come out of the closet’.
1 - John Authers, ‘Active management industry in bafflingly good health’, Financial Times, May 4th, 2014.
2 - Antti Etajisto, "Active Share And Mutual Fund Performance," Financial Analysts Journal 69:4 (July/August 2013): 73-93.