The active fund management industry could be under threat once more as the rise of a specialist form of passive investing looks to replace costlier alternatives.
According to a recent report on ‘The future of fund management’, analysts at investment bank Nomura predicted a rise in “factor” investing, a version of what has become known as smart beta.
This is where passive funds are created to follow specially constructed indices of stocks that meet certain criteria, such as growth or value.
Nomura’s quantitative strategy team said the increased focus on “closet index-huggers” in recent times could then translate to a focus on “closet factor-huggers” – managers who simply buy up stocks exhibiting, for instance, value characteristics rather than genuinely analysing businesses.
Nomura authors Inigo Fraser-Jenkins and Alla Harmsworth said the “level of activity question”, in which people judge active funds based on criteria, such as active share or tracking error, should become broader.
They argued instead of just judging managers against their chosen benchmark, generally a market-cap-weighted index, analysts should look at funds against a range of benchmarks.
Using factor indices, analysts could then “regress” a manager’s returns, working backwards to find what portion of the fund’s performance was attributable to a style bias and what was down to genuine stock picking.
The Nomura report argued that although most managers would claim to be stock pickers, a large proportion instead relied on certain style strategies that were replicable cheaply in specially constructed smart beta index trackers and that “actual stock selection is very rare”.
A proliferation of factor products could force asset management firms to cut the fees on their active funds, or abandon funds that were not focused on idiosyncratic stock picking, the report suggested.
It added that normal market-cap-weighted tracker funds would in future be predominantly priced at 10 basis points or lower. Smart beta or factor index trackers would then be priced between 10 and 40 basis points, but that genuine stock-picking funds could command a premium, charging up to 100 basis points.
So while the active management industry as a whole may see a fall in assets and profits, true stock-picking funds may eventually charge more than they do at present.
But the authors said the implications of its theory were that “the aggregate fee earned by the fund management industry would fall considerably”.
However, the threat to active management for retail investors in the UK is not particularly imminent due to the lack of smart beta products widely available.
BlackRock’s exchange-traded fund (ETF) business, iShares, has launched a range of factor ETFs listed on the London Stock Exchange, but there are few open-ended fund options available for retail investors.
Discretionary managers question the rise of smart beta
Discretionary managers have called into question whether smart beta products will become a dominant force in the UK retail market, in the wake of Nomura’s report into the industry.
Nomura concluded the rise of smart beta would cause pain for active managers, particularly those who are “closet factor-hugging”.
But James Calder, research director at City Asset Management, said smart beta products would need to build up a much longer track record than they have to convince investors they can be effective replacements for active managers.
He said these computer program-driven investments had a history of going badly wrong in certain market conditions.
Lakewood Portfolio Management’s Andrew Alexander also predicted the rise of passive and smart beta products could be derailed in the next big market correction, in which he expected “trackers will take the full brunt”.
