Active fund management has suffered because of high costs and poor performance – abysmal performance I might add. Money is leaving active funds at an incredible rate. And the exit is not slowing down, it is accelerating.
As returns on investment overall go down, it will only get more difficult for active managers to outperform. So active management is dead, right? No, not so fast. We do not think it is necessarily dying.
But we do think it is evolving. And, it absolutely must evolve in order to survive.
We know what the old traditional active looks like. But what does the new evolved active look like?
Traditional active
Well, first of all, let’s look at traditional active. Despite the fact that it is really, really difficult to outperform, it can be done. There are some good managers out there. But they have got to cut their prices – a lot.
They have got to reduce their expenses an awful lot just to have a chance to outperform.
The chart shows performance for a number of core asset classes, including equities and bonds. The square dots represent the lowest quintile of funds in each asset class, ranked by cost. The diamonds show the funds in the highest quintile ranked by costs. As we can see, the square dots, representing the lower cost funds, tend to have had better performance than the higher cost funds. Not in every case, certainly, but to a large extent. But if we look at results within asset classes, we will see that the lower-cost fund has always outperformed.
Managers with low costs have an advantage. They’re not saddled by high expenses, so that a lot more of the value that they add on a gross basis flows through to the client. So that’s the first evolution of active that we can see. It should be the easiest, though perhaps not.
The second form of evolved active management that we see is actively managed passive portfolios. That is professional investment managers expressing their views on the market with portfolios of exchange traded funds. As an alternative to individual securities or mutual funds, or regular active mutual funds, using ETFs is inexpensive, highly efficient and transparent. They trade very easily and liquidly. Now it is hard to get really good data on just how much this phenomenon is growing. But we see a lot of growth and a lot of interest from the people that provide those portfolios as well as investment advisers looking for a more efficient way to manage their portfolios.
We can see this evolution in the growth of ETFs. In 2011, Morningstar tracked 370 ETF managed portfolios with US$27bn (£20.8bn) in assets under management. Morningstar currently tracks 838 ETF managed portfolios, managing $88bn (£67.9bn).
Factor investing
Then the final evolution that we see of active currently is factor investing. This involves investing directly in risk factors such as value, momentum and volatility. Factors are often called the DNA of individual securities. And they are at the heart of the ‘smart beta’ or ‘strategic beta’ strategies that are currently getting so much attention.
So to paraphrase Mark Twain, we think the reports of active management’s death have been greatly exaggerated. Is active dead? No. But we think the old active is unlikely to survive. It needs to evolve if it is going to live on.
As the FCA’s recently published report on the UK asset management industry makes clear, costs matter. Every pound that investors pay in charges is a pound out of their potential returns, reducing their chances of being able to save for the future.
So what does that mean for us? What do we do with all this information? I think it is about awareness. First of all, be aware of cost. If I have not made that point, costs are important. Be aware of what you are paying. If you are going to use active funds – traditional active funds – demand low costs from your active managers.
This evolution we are seeing is a big idea. It is really exciting for the industry. It reminds me of Jack Bogle back in 1976 creating the first index fund. That was a big idea. It took a long time to come to fruition. But it is going to enable us to better serve our investors, and I think it is a movement we can get behind. Finally, it is about awareness of how these strategies work. Do the research, be open-minded, but be sceptical. Remember, there are no shortcuts to investing.
Neil Cowell is head of UK retail sales at Vanguard UK
Key Points
Active management is evolving.
Managers with low costs have an advantage.
The final evolution on active currently is factor investing.
