By Steve Borowski, President Aristotle Capital Management, LLC – full bio below
The financial services industry is amazing. You can’t help but roll your eyes and marvel at what contraption they come up with next. Lately, there has been a bevy of well-financed academic sounding white papers produced by large financial firms all espousing the same theme: active bad, passive good, fee compression and the ever increasing need for alternatives. Conveniently, each of these firms has the people and infrastructure in place to capitalize on whatever it is being extolled.
Why did Jesse James rob banks? Because that’s where the money is! Supplant the banks of old with pensions, endowments, foundations and other asset owners of today. Only this time the bank tellers are willing accomplices. In an underfunded world, this hollow promise of superior returns is music to investors’ ears.
I understand the frustration with active management. If most of the active options available to me did not add value, I would be frustrated too. I would also suggest that much of the underperformance by most managers is not accidental. In the life cycle of many firms, once a level of critical mass (as measured by assets under management, revenues or how much money key people are making) is reached, something changes: you no longer play the game to win. You play to not lose. Your focus shifts from doing what is in the client’s best interest, namely adding value, to what is in your best interest, which is to protect your revenue stream. How do you do that? You start by not losing what you have already got: don’t get fired! And how do you do that? By finishing in the middle of the pack, along with the mediocre majority.
Gone are the days where a single investment firm was the manager of choice for a client. Nowadays, most investment managers typically are one of many. The mindset of too many active managers is that if you do something out of the norm to add value; you are incurring a degree of risk which could go either way. If it works, great! The client benefits and you finish toward the top of the pack. What if it does not? You could be near the bottom. Spend much time there, which in an instant gratification world, means quarters as opposed to years, you could lose that relationship and its accompanying revenue stream. I am aware of one very large investment firm who rewards its portfolio managers for finishing within 50 basis points of their respective index. If your benchmark returns 6.00% and you return 6.25%, you are personally rewarded more so than if you returned 8.25%. Why? Because the perception is that you have incurred more “risk” by attempting to add value. Again, what if you are wrong? You potentially put the revenue stream at risk. That is viewed as too great a business risk. Welcome to the modern world of investment management!
I am a big believer in cyclicality. Life generally shows that, no matter the subject, if the pendulum swings too far one direction, it is bound to snap back. Sometimes violently. If the crowd does one thing, do the other. In the investment world, hardly immune to the herd instinct, conventional wisdom has it that active management is, if not already there, rapidly becoming extinct. Markets are too efficient. It is believed that active management cannot add value, especially taking into account fees. Problem is what is coined as the Active/Passive Conundrum is based around how the average investment manager performs. The argument is that since the average investment manager does not add value, all managers cannot add value. That is like saying Tom Brady and Johnny Manziel, both NFL quarterbacks, should be viewed as one in the same. Suffice to say, individually their NFL experience is a bit different. And New England Patriots fans, the clients in this case, have been justly rewarded.
Here is the problem: Equity indices are typically capitalization weighted. With the massive flow of capital into passive indices we have experienced, the biggest companies get bigger and have a disproportionate effect on performance. Five companies—Apple, Microsoft, Alphabet, Facebook and Amazon—roughly account for a combined $3.0-trillion market capitalization as of the end of September 2017. That is roughly 10% of the entire U.S. equity market.
This massive inflow of capital into passive strategies rewards potentially less-deserving companies alike. Netflix, although a fan of the service, is hardly a bastion of financial success and, (coincidentally producer of the series House of Cards), currently has roughly an $85-billion market capitalization and sells at a trailing price/earnings ratio of over 240x as of the end of September 2017. Has its market success been justified or has it simply come as a result of the massive inflow of passive money? You be the judge! Unfortunately, there is little sign of this trend abating. Vanguard, the pioneer of index investing, has masterfully ridden this wave to become wildly successful. At the end of 2016, Vanguard boasted a total assets under management of roughly $2.7 trillion in passive strategies. However, has it become too successful? It was reported that, in 2005, Vanguard held three companies where they had 5% or more ownership. As of October 2016, that number of companies had allegedly increased to 468. And that 5% is a floor, not a ceiling! The market is up meaningfully since then so that number is undoubtedly higher today. Blackrock, the second-largest passive fund manager, with $1.3 trillion in passive assets as of December 31, 2016, had $103 billion flow into their index funds, ETFs and other low-cost funds in the second quarter of 2017 alone. Additionally, the CFA Institute recently reported that 90% of all flows into equities were directed to passive strategies.
Why is this an issue? Truth be told, so far, it has not been. But it could be! Indices are basically algorithms. At its simplest form, indexing can be described as nothing more than a systematic selection that is performed using a characteristic or group of characteristics, such as market capitalization, countries/regions, sectors, statistical ratios, for instance, that were deemed to be observed in successful investments in prior periods. They are theoretical in nature. Theory and practice are two different things. An algorithm assumes you can sell an unlimited number of shares at any time and at the prevailing price, and there is a willing buyer on the other end of that trade to complete the transaction. In reality, that is not the case. With such a massive amount of capital deployed into so few names held by so few hands (the indexers), not if but when this onslaught eventually slows down, or stops, or goes in reverse, we could experience a massive illiquidity event like never before.
Do active managers own many of the same names as the passive managers? Of course they do! The difference is that active managers do not need to sell if they choose not to, but, when facing redemptions, index funds do—assuming market conditions allow them to. The ability to control and decide when to buy or sell is one of the main advantages of active management. In times of great volatility, active managers have the capability to respond to market changes and adjust their portfolios accordingly, while passive managers are stuck replicating the volatility of the area of the market it is tied to. We believe the impact of this relationship is the greatest when frothy markets slow down or, more importantly, when a market bubble bursts. Passive managers are typically left with securities that are no longer in favor and often times are overpriced by the market. When everyone tries to get out the same door at the same time, good luck!
Aristotle Capital Management, LLC
About the Author
Steve Borowski is President of Aristotle Capital. Steve began in the investment industry in 1980 and has experiences in equity and fixed income markets. Prior to joining Aristotle Capital, Steve was co-founder and Managing Partner at Metropolitan West Capital Management, LLC for 13 years. Previously, he was Managing Director at Palley-Needelman Asset Management, Inc., where he first established his partnership with Aristotle Capital’s CEO and Chief Investment Officer, Howard Gleicher.
Steve earned his Bachelor of Arts degree from University of California, Irvine and his MBA from Pepperdine University. He serves on the Investment Committee for the Blind Childrens Center in Los Angeles and on the Board of Directors for the Orange County Youth Sports Foundation, the UC Irvine Chancellors Club as well as the UC Irvine Athletic Association.
See the full PDF below.