Is Active Investment Management Facing Extinction?
April 04, 2017
As reported in the March 2017 The Wall Street Journal article "Where To Find Active Fund Strategies in a Passive World," according to Morningstar, investors redeemed $342.4 billion from US-based actively managed funds last year while committing $505.6 billion into US passively managed funds. Hedge funds, the ultimate proxy for active investment management, suffered their worst year ever in 2016 both in terms of record withdrawals and closures. Granted, most captive insurers are not investors with hedge funds; however, the trend represented by hedge funds in terms of performance is indicative of how many active managers also have fared since the end of the financial crisis. Investors are being told active management, with its higher frictional costs, is no match for lower cost passive strategies, such as those using index funds. While this debate is not new, it has taken on additional urgency during a period of extremely low rates and fairly low volatility.
When it comes to active investment management versus passive investment management, how do captive insurers choose? The argument for active managers is based on the skill of the manager to add alpha. “Alpha” is defined as the excess return above the return of the market index or benchmark. Opponents of active investment management point out that most active managers fail to best the index produce alpha (i.e., beat their index) on a consistent basis. This inconsistency is further degraded by the higher fees associated with active management, where, after fees, the active manager actually under-performs the benchmark. Had the captive insurer invested in a similar index fund, it would have come out ahead.
While the pendulum has certainly swung in favor of passive investment strategies within the last 5 years, captive insurers would be wise not to discount the need for active management. Below, we explore some of the reasons why active investment management is never likely to become extinct and should always be considered as part of an overall investment strategy.
At the 20,000-foot level, let’s start with a basic distinction between an active investor and a passive investor. Active investors, and hence active investment management, tries to beat the market on a risk-adjusted basis, while the passive investor is content with taking the market return. But in the truest sense, even passive investors are active investors. All benchmarks, index funds, and exchange-traded funds (ETFs) are really a subset of the portfolio of all outstanding financial assets. Therefore all index funds and ETFs represent an “actively” selected slice of the overall global market. Cullen Roche has written about this distinction in his article “The Myth of Passive Investing.”
As we have noted, active managers do not consistently outperform the index. However, for captive insurers, where fixed income securities tend to be the main component of their investment portfolios, the argument is not as strong. The following chart shows both managers of US intermediate term bonds and US blended large-cap equities. 1
The median active bond manager has outperformed both the benchmark and passively managed accounts while the median large-cap equity manager has under-performed in both categories. One reason for this difference may be that bond prices and yields can vary more from issue to issue and from sovereigns to corporates to mortgages, leading to greater dispersion in the results as compared to large-cap stocks. This brings up one of the main reasons why active investment management is likely to survive. The ability for managers to provide unique insight and glean information that may escape others can allow those managers to capture alpha versus the index. Active bond managers typically employ credit research teams and risk analytics professionals charged with capturing this information. This, of course, is beyond the scope of passive strategies.
But the capture of alpha is only one side of the coin. Active managers tend to be more risk averse and incorporate this aversion into their strategies. For captive insurers, the elimination of volatility in their portfolios can be as important as capturing excess return. Downside risk is as important, if not more important, than upside risk. Active management can potentially lessen the effects of market downturns when compared against a purely passive approach. There is also new evidence that ETFs are much more volatile during extreme market movements than had previously been thought possible. Captive insurers, in times of market crisis and faced with liquidity needs, don’t want to find their ETFs trading at extremely low prices as compared to their underlying asset prices.
Another reason to discount the demise of active investment managers, especially in the fixed income space, is the fee compression that has occurred since the financial crisis. For a typical captive portfolio of cored fixed-income assets, fees have fallen from the 20–25 basis points down to 10–12 basis points. Typically included within this expense is all of the investment accounting necessary for the portfolio. In some cases, the fees also include custodial costs. When captive insurers add in the actual expenses associated with these services on the stand-alone basis required for passive investing, the frictional costs of active investing are often no longer a differentiator.
Lastly, outside of core fixed income, captives looking to diversify their portfolios will probably utilize a combination of active and passive management. For securities with complexity or illiquidity, which include emerging market equities and debt, small-cap stocks, private placements, and specialty below investment-grade fixed income (e.g., distressed debt), active managers bring expertise to the table that is lacking in a true passive strategy.
The past decade, with its low interest rates and low volatility, has been a difficult time for active managers. However, for investors, it has brought renewed focus on frictional costs and the attributes that active managers bring to the table. Going forward, active managers must continuingly compare their fee structures and their performance making adjustments as necessary to remain relevant. However, they will have a role to play in the global market.
If you found this article interesting and useful, you might also read the article "Uncertain Times Squared: The Future of Investing for Insurers," by Alton Cogert, on the future of investing at Captive.com.
- Source: Morningstar—December 31, 2016, based on Morningstar’s U.S. Intermediate-term Bond Category for fixed income and Morningstar’s U.S. Large Cap Blend for equities. Benchmarks: Bloomberg Barclays U.S. Aggregate Index and S&P 500 Index.
April 04, 2017