On the face of it, as multi-asset managers we should be indifferent as to whether we use active managers or passive investments through ETFs.
Our goal is to achieve the best outcomes for our investors and we don't get rewarded any more or less for using active managers over passives.
Indeed we have used ETFs in the past to gain exposure to vanilla UK government bonds, where we believe it can be very difficult for an active manager to add value after management costs.
Having listened closely to the arguments for passive investing for a number of years I’d like to highlight what I believe to be some of the drawbacks.
A large part of the evidence presented by passive supporters centres around a ‘buy and hold’ strategy. However, the reality appears to be that most investors do not employ ETFs in this manner and instead are typically trading them frequently.
This leaves passive investors just as open to all the behavioural pitfalls of fear and greed that are part of human nature.
It would be impossible to have a functioning market made up solely of passive investors.A further assumption is that active management means high portfolio turnover. You needn't look much further than Nick Train of Lindsell Train to see that successful active management doesn't have to mean high turnover.
When we search for high quality active managers we want to be aligned with good long-term results from high conviction investing and not being reliant on benchmarks for investment decisions and portfolio weightings.
This also brings into focus the notion of relative risk. Using a passive fund might reduce the risk relative to the benchmark it tracks but it says nothing about the absolute level of risk being taken.
This is especially the case where many passive stocks are selected using one criteria: their market capitalisation. So you are effectively buying into yesterday's winners, even though these ‘winners’ may have increased valuations and correlation to other stocks purely as a result of being part of an index.
Costs for investing in ETFs can be very low for the more mainstream indices, but when you begin to look outside of the most popular indices then passive doesn’t look so cheap.
This brings me to what I believe to be one of the biggest challenges with passive investing, and also one of the biggest opportunities for active managers: price discovery and efficient markets.
With ETFs indifferent to the price of stocks, they are solely reliant on active managers to carry out research and collectively reflect this in prices that reflect the information available.
They also rely on active managers to create liquidity in markets. It would be impossible to have a functioning market made up solely of passive investors. Active and passive investment must co-exist.
One benefit of the rise of ETF sales is that it is, indirectly, helping weed out the closet trackers, leaving managers that are truly active.
This could lead to a much better cohort of active managers, who are able to take advantage of misvaluations created by the crowding of assets flows out into passive investments. It just may take a lot longer for the misvaluations to be corrected.
With more and more money flowing into ETF tracker funds, as we look across the active and passive landscape for appropriate investments, including across many different asset classes and markets, we have never held a stronger view that good and proper active managers can add really good long-term absolute and relative value for our clients.
David Thornton is senior fund manager at Premier Asset Management
