The rise of passive investment presents some serious challenges to asset owners, fund management firms and society as a whole. For the shift to create a more sustainable investment environment, a new balance needs to be struck between better capital allocation decisions, better passive offerings and a more equitable sharing of risk and reward. Without that, the rise of passive could do untold damage to long-term returns.
There’s good news and bad news: passive is on the rise.
According to data compiled by Morningstar for the FT, passive funds grew 4.5 times faster than their active counterparts during 2016. Meanwhile, research from Moodys shows index tracking could become the dominant form of investment in the US by 2021. This may spell good news for savers whose assets have suffered as a result of high active management fees in the past, but it is potentially very bad news for both economies and societies as a whole.
The bad news
Lets get the bad news out of the way first: Capital allocation decisions are all important. Active capital allocation is what determines which companies succeed and which don’t. It is an absolutely vital cog in shaping the world of tomorrow.
Consider for example, the transition to a low-carbon economy: active decisions could see investors divest from fossil fuel companies or identify opportunities to engage with those companies to force through a more carbon-friendly approach. Government policy is simply not driving this process fast enough so we are reliant on capital markets if we are going to succeed in limiting global warming to 2°C.
Passive investment is not capable of making this kind of value judgement. Tracking an index is like putting that decision-making process into autopilot. It undermines the notion of allocating capital based on which companies represent the best chance of achieving sustainable capital growth and returns in the long-run. It undermines the whole notion of capitalism by separating sound analysis from the allocation decision.
This is because, particularly where it comes to mainstream, market-capitalisation weighted indexes, it is not the job of the index provider to make those value judgements.
And if passive becomes dominant, and hence the majority of assets are not allocated based on those value judgements, we will end up with a highly dysfunctional system focussed on short-term gain and locked into a more volatile boom and bust cycle.It is in the nature of many of the most established indexes to attribute the greatest value to companies right before they crash and the least to companies right before they rise. This pro-cyclicality exposes investors to bubbles and crashes, and, as more money chases the same indexes, those peaks and troughs will get stretched. While that will mean more upside, research repeatedly shows investors place a greater emphasis on downside risk and would be willing to forgo some potential gain to protect themselves from losses. Passive doesn’t make that distinction.
Furthermore, if the move to passive were taken to its extreme, economies and society would grind to a halt. The only thing that drives indexes up or down is the collective decision making by active managers. This extreme scenario is, of course, unlikely to actually materialise. Eventually, the swing to passive will reach a point where it opens up more opportunities for leaner, smarter active managers to exploit and a balance will be eventually be struck. But there is a long road to walk before we get to that point.
The good news
Now to the good news: there can be little doubt that many active managers have failed to provide value for the high fees they charge because they too have not been making enough of those value judgements (or not been making them well enough).
The active management industry has rightly come into sharp criticism for its high fee structures, which are particularly punitive for smaller asset owners. Yet, despite considerable public pressure and the persistence of the low-return, low-interest rate environment, which has forced asset owners’ attention onto fees, asset management firms have been able to maintain their profit margins at around 36% on average, according to the FCA’s data. (These margins apply to both active and passive managers, but passive management has had to compete on fees as ETFs have grown in popularity, suggesting the persistence of their margins is due to better cost management and sleaker operations.)
The lack of fee compression in the active space suggests the industry is dysfunctional and needs to rethink how it shares the gains of its activities. It’s not reasonable for investors to assume all the risk of investing through managers and then hand over the rewards to those managers too.
It’s nonsensical and makes large parts of the fund management industry unsustainable. If the move to passive forces a rethink on active management fees towards a structure that more equitably shares the risks and rewards of allocating capital, that can only be a positive thing.
As Andrew McNally, CEO of Equitile Investments says: “The rise of indexation has happened largely because the active management industry as a whole has not designed a fee relationship that encourages it to do what it was meant to do from a societal point of view.”
Management fees, in particular, act as a tax on society that encourage managers to gather and retain assets, rather than equitably increase wealth though sound judgements about which companies represent real long-term value.
Something has to give and that is likely to be a combination of three things:
Without those three things, the trend towards passive could do untold damage to how our economies and societies function, which would make returns unsustainable in the long-term for all involved. It is incumbent on all parties – active and passive managers, consultants, fiduciaries and savers – to play their part in turning what could be bad news into good news.
(The best ideas are born of collaboration and discussion. If you agree or disagree with any of the arguments above, or want to expand on the topic, please add a comment below.)
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A quick cuppa with Faith Ward, Chief Responsible Investment and Risk Officer, Environment Agency Pension Fund