There is a movement, a trend taking place and it “is not temporary,” a Moody’s Investor Service report observes. This isn’t a political movement that jeers at a political convention over mention of the nomination process victor. This movement is going to “accelerate.” Unlike the factions in politics, this movement from active to passive investing will lead to transformational change in the investment industry.
Trend from active to passive started in 2000, was masked by stock market appreciation
Real demand for active equity mutual funds saw its heyday in 2000, just prior to the “Tech Wreck” of 2001 that witnessed an unsustainable bubble burst.
In a July 25 report titled “Industry Flows Actively Moving to Passive,” Moody’s point to a shift from active to passive that began to take place in 2000. While overall assets under management received a bump due to a never-ending stock market expansion leading up to 2007, decisions to place new money to work in active mutual funds told the real story of decline. This trend to eschew active in favor of passive significantly accelerated after the 2008 financial crisis. Currently the asset flow trend out of active managers is more acutely visible in not just the movement of assets, but more pointedly in the drop in earnings among active managers. As active managers are attempting to adjust their business models but a troubling correlation breakdown is occurring. Even as recent assets under management increase, the earnings (EBITDA) fell.
This has resulted in a rise and fall of business leadership. Vanguard Group, the leader in passive investments, has taken more net assets from investors than the rest of the asset management industry combined — and the industry leaders are experiencing a reshuffling.
Performance wows and costs at the heart of active manager problems
In large part the trend of investors from active to passive approaches is due to performance. RBC Capital Markets, in a January 2016 study, showed that betting on an active manager to beat the market isn’t a high probability play. (Other studies have illustrated mixed results.)
In the RBC report active managers as a whole delivered underperformance, missing their benchmarks, for more than three decades.
“We believe that it is reasonable that active management as a whole underperforms passive by approximately 200bps (2%) per annum – the sum of fees and frictional costs, before investment underperformance and survivorship bias are accounted for,” Moody’s wrote. Not only do they underperform, but Moody’s notes this underperformance comes at a higher cost. Transaction costs for the average actively managed mutual fund, for instance, been estimated to be an additional 144 basis points (1.4%) annually, Moody’s noted.
On a statistical basis, active management is an expensive proposition for the investor, but Moody’s points out the active fund manager themselves have little exposure to the same negative forces as do investors.
“In a low-return environment, a fund manager can easily take home more of the economics than the end investor – with the investor assuming all of the downside risk,” the report stated.
Overcapacity, regulation and a low yield environment is like a falling tide highlighting poor performance
The problem for active managers is the current market environment. Much like the proverb of the low tide revealing who is swimming naked, a low yield environment is exposing the active manager and the impact of their underperformance. “These fees and frictional costs are also far more noticeable in the current low-yield environment than they would otherwise be if risk-free rates were considerably higher.”
A degree of the problem might be found in overcapacity, Moody’s notes. in 1962 there were nearly 3.3 mutual funds for every stock in the S&P 500 Index. Today there are 9,520 mutual funds, 10,000 hedge funds chasing performance among 500 stocks in the S&P 500 and 3,691 stocks in the Wilshire 5000.
“Overcapacity leads to investment mediocrity, since true talent is limited and size works against the investor in the form of increased transaction costs and difficulty in identifying scalable investment opportunities,” Moody’s writes. “An investment truism, ‘Size is the enemy of returns’ still holds.”
The realization that active managers underperform the market is seen materializing in other developments, including the Department of Labor’s new fiduciary rule that, in effect, penalizes a financial advisor from recommending higher fee actively managed products.
Active manager’s retort is “smart beta” but this changes the fund’s business model
Active managers have begun to react to the shift to passive by developing more passive investment products. The rise of “smart beta” ETFs is a method by traditional asset managers to transition into a passive arena with a product that some say is active in its nature but marketed as passive.
But increasing competition from active managers into the “passive” arena is likely to cause a similar modeling of returns with little distinction to justify fees. “The competitive landscape in this area remains open as there are no clear market leaders, enabling new entrants to gain a foothold in the growing passive or quasi-passive product category,” Moody’s observed.
Some fund managers are climbing on the “smart beta” shift with aplomb. “Given the scalable nature of quantitative investing, the large number of smart beta managers is also likely to shrink to a few surviving winners managing large amounts of capital. Firms pursuing opportunities in ETFs and smart beta include FMR LLC (Fidelity) (A2 stable), Janus (Baa3 stable), Invesco ((P)A2 stable), Legg Mason (Baa1 negative), Eaton Vance (A3 stable) and Franklin Resources (A1 stable).”
One trend is clear. Traditional asset managers who wade in passive investing waters “will likely see margins compress as a result of adverse asset mix shifts into these lower fee products.”
The prospects of the active managers can, in part, be seen by looking at the resultant ratings of various managers. Traditional active managers such as Waddell and Reed (Baa3 negative), Legg Mason (Baa1 negative) and Gabelli (Ba1 stable) have experienced ratings downgrades. On the opposite side of the trend, passive managers such as Blackrock (A1 stable) and State Street (Aa1 stable) have seen upgrades.