But, these trends are actually a positive development for active managers. The so-called passives, with their buy-and-hold and index-tracking strategies, have been to asset management what Uber is to taxis—a disruptor exploiting the weaknesses of an established industry. The label "active" has long allowed fund managers to charge high fees for essentially reproducing an index. With the availability of lower cost passive products, these 'closet indexers' are increasingly under pressure, allowing truly active managers—conviction investors divorced from any benchmark—to stand out.
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In fact, the opportunity set for active strategies has substantially improved. As more capital is allocated to passive products, pricing inefficiencies—which active managers seek to identify and benefit from—rise. So when investors shun active managers for their perceived inability to beat the index, they actually create a wealth of opportunities for those that persevere.
Critics of active management point to evidence that the average active manager has under-performed benchmarks in recent years. In many cases the underperformance is striking. But this doesn't tell us anything about the future, unless, of course, we assume that the investment environment will remain exactly as we have experienced it over the past six years. This is highly unlikely.
Since 2008, asset prices have been driven by coordinated and unconventional central bank policy. This unprecedented broad-based lowering of interest rates and surge in global liquidity from quantitative easing has compressed yields, and driven up equity valuations. It is no surprise that active managers have struggled to gain an edge.
As we transition into 2015, this macroeconomic backdrop is fundamentally changing. In the U.S., the Federal Reserve is exiting quantitative easing, and soon to end half a decade of zero-interest-rate-policy. With about 50 percent of the world's financial transactions denominated in dollars, this policy change will ripple through large parts of the global economy. The central banks of Japan and the euro zone are heading in the opposite direction. Both are committed to further expansion of their balance sheets, and rate hikes are out of the question in the near future. At the same time, China is following its own path with the globalization of the renminbi.
These developments will have meaningful implications for asset class returns. US equities trade at rich valuations and will no longer be buoyed by a flood of liquidity; hence, index returns will struggle to repeat recent performance. Over the past three years only 21.5 percent of stock funds were successful in topping the S&P 500. But if we look back 10 years, the index was outperformed by more than half of US domestic equity funds. It is going to be a stock-pickers market again.
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Furthermore, years of ultra-loose monetary policy have compressed fixed income yields across the board. Flexible active asset managers are able to hunt for yield in areas under-represented or ignored by passive products and can minimize rate and yield curve risk in ways impossible for an index tracker.
The logic of active management applies even more strongly to emerging markets. The growth in passive management products in this area has been more pronounced than for developed markets, increasing from 13 percent of total assets in 2003 to 44 percent in 2014. Considered often as one 'asset class', emerging markets are in fact a highly divergent set of economies. The Chinese economy grows above 7 percent, but Brazil is barely in positive territory. As Russia struggles, India benefits from the structural reforms of its new Prime Minister. Within individual emerging market countries, the performance of unique sectors and companies is even more divergent. How is a passive strategy, built on index weightings, supposed to navigate such diversity?
The fixed weightings that characterize most index products leave investors vulnerable to changing market dynamics and macro shocks. A recent example has been the collapse in the oil price. Passive products had to bear the brunt of the losses from the sell-off in energy stocks, due to their fixed – and in many cases overweight – exposures to the sector. Junk-bond exchange traded funds have lost almost twice as much as the broader index of high-yield debt since the end of August, partly because of their bigger allocation to energy companies.
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Finally, demographic trends call for the active management of growing retirement savings. In the developed world, the number of retirees is increasing at exactly the time that governments reduce their social nets. Higher returns on invested assets will be sought to fill the void, and these are unlikely to come from broad-based market indices. Same for China, where a slowing economy and the one child policy playing out in reverse has led to a need for greater resources to care for the elderly. Indeed, across the developing world, growing middle class wealth is largely generated by entrepreneurs, a group far more comfortable with an active investment approach than a passive one.
A renaissance for true active management is right around the corner.
