Active-passive debate

Some active equity managers argue passive undermines price discovery. Rubbish. Nor should stock pickers be so defensive – their fortunes are looking up.

Executive summary

  • The rise of passive is a phenomenon. However, a small and vocal backlash has begun. Equity index trackers are accused of undermining free markets and the efficient allocation of capital. One report even called passive “worse for society than Marxism”.
  • We believe these critics are mistaken. They also tend to be active managers, who understandably feel threatened. This paper has two objectives, therefore. First, to show why passive has nothing to do with price discovery or communist plots. Second, to persuade stock pickers they need not be so defensive. Their current woes are in large part cyclical, not structural.
  • That is because the rise of passive is the result of changes in the investment environment – not the other way round. Economic fundamentals have caused the dispersion in total shareholder returns among companies to fall over the past two decades, making it harder for professional active managers to generate alpha. Passive is merely a rational response to this trend.
  • But dispersion is already widening again, with active managers performing better since the start of 2017. What drove dispersion down over the past 20 years was that even low quality companies could grow their margins. They benefited from a sustained decline in interest costs, wage pressure and effective taxes. All three of these are either reversing, or the large gains will not be repeated.
  • As poor quality companies are found out, return dispersion should rise, as it has done for the last 18 month or so – helping active managers. In fact there has been a reasonable correlation between alpha and passive penetration, with the latter tending to be lower where active managers have performed better versus their benchmarks.
  • If a large part of the passive story is cyclical, then active and passive should not be seen as contradictory investment philosophies but rather as specialised approaches to differing economic and financial conditions. When companies are affected in a way that reduces their ability to produce differentiated returns investors should favour passive. When the reverse occurs a more active approach has a better chance of producing outperformance. Smart-beta lies somewhere in between.
  • The conclusion? Asset managers that do not offer their clients all three approaches across the spectrum – active, passive and smart-beta products – are potentially denying them the change to profit from a shift in the macroeconomic backdrop.
  • Click here to read the whole Article.

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