Investors are disillusioned with active investment.
Once the staple of institutional and retail investment practice, active now has an awful image – one of high cost mediocre offerings.
While the rot was initially confined to equity, it has started to seep into fixed income. Here we try to understand why, and offer a simple solution, which may yet short-circuit this damaging trend, before it’s too late.
Why not Active..?
The active management game has been suffering from three issues:
- The “World Champion effect”
- The impact of low rates – cost obsession
- The hibernation of the Bear…
The result: mounting derision with active investing and the growth of “low cost” passive and ETF products.
The solution: the blackbirds – performance-related fees.
What’s ailing Active Investment?
The troubles faced by Active are no doubt complex.
Here I discuss three concepts that I feel captures the bulk of those troubles.
I also discuss them in detail in a recent video post.
1. the world champion effect
Investment has always been a game of personalities, and we’re used to household names – Peter Lynch, Julian Roberson, George Soros, Bill Gross
and more recently Jeff Gundlach…the new King of Bonds…
When I was growing up, boxing had the Ali/Foreman/Frazier era, where even the lady on the checkout counter knew who was champ.
Then we went through a long lean patch where no one knew who was champion at any weight – only diehard fans know these days. Care to name a current heavyweight boxing champ?
I think we’re entering a similar phase now in investing – and it’s only just begun.
Believe it or not, when no one knows who to follow, everyone is somewhat lost. These “champs” act as lodestone for the investment debate – they frame the discussion and help markets achieve the correct result. Without them, the debate relies upon non-risk-takers like strategists, economists, or, heaven forbid, perhaps even central bankers and policy makers.
The industry needs champions who win at least some of the time. Otherwise, the whole active industry, from hedge funds to real money, can be tarnished with the same brush – the expectation of failure and mediocrity.
2. the impact of low rates – obsession with cost.
No one can dispute that management fees seem high in all asset classes.
Meanwhile policy has been aimed at reducing volatility of return and reducing the absolute yield on risk free assets to “crowd” investors into riskier assets. Combined with potentially lower equilibrium return profiles, future return projections are low. The low return/vol environment has also led to weaker active management performance.
But just like the tendering process for your wife’s kitchen, is the lowest tender really the best value for money?
Value for money (aka performance ) had always counted for something, but with low rates and heavy Central Bank involvement making it hard for the industry to add alpha, the focus has switched to cost.
And the raw fact is that, as yields have fallen, a 20bps (0.2%) fee has become a huge percentage of the 2% yields on offer. Compared with the past, 20bps looked minuscule versus yields of 5%.
Obviously, as the market return has fallen, the value of the target active outperformance (alpha) of say 100bps (1%) has also improved in ratio terms. Sadly that alpha has been harder to come by in these heavily policy-insulated markets.
Passive management has made hay simply as the active cost ratio has climbed, and investors have lost sight of the “shadow costs” of passive – that passive managers slavishly follow indices laden with fully-valued stocks or the most indebted bond issuers.
3 the hibernation of the Bear.
Since the great financial crisis of 2008, Central Banks have rightly been determined to reduce the downside in most markets. Consquently the size and frequency of “bear markets” in both stocks and bonds has collapsed. Little wonder that investors have had little reason to care about the value an active manager brings in reducing market risk in a bear market.
It may be hard to remember, but even equity managers tended to outperform in bear markets. Of course some of that is due to accumulated, uninvested cash inflow as investors add to funds in a down market. But in some cases active managers actually smelt the coffee.
Of course as dips become minimal the investor only values positive absolute performance, and the active manager is forced to be fully invested just to keep up with return insensitive passive funds. The has been the case more and more in recent years.
The side effects of panic.
I realise senior management in active firms have become obsessed with the way “passive is eating their lunch” but I feel any change to investment DNA forced by fear of these recent trends would rest in poor outcomes for both clients and the managers themselves.
I’m actually optimistic that as policy is gradually normalized, we’ll see macro investing, and active with it, return to form – as recent behavior has indicated – active is back!
Furthermore, a lot of things can go right – rates and yields can normalize, volatility can return reminding end investors of the downside protection a good active manager can give you. Or the champions can start to come back – hey even Muhammed Ali had a second coming!
But I feel the simplest solution is what I call the blackbirds…
We’ve all heard the nursery rhyme “four and twenty blackbirds baked in a pie”
Most of active management is remunerated by fixed fee – I’m used to seeing 20bps in a typical institutional fixed income mandate.
Well I’m suggesting we go from fixed fees (20-100bps) and hope, to a performance based fee.
e.g. 4bps and 20% of any alpha above a set benchmark or target…
Four and twenty…
If active really can make money, and I’m confident some can (but you have to pick your builder wisely whatever the tenders – hey it’s the wife’s kitchen!!), then a performance related fee won’t cause any concern – the 4bps will make sure the light bills are covered during a lean phase, while the bonuses will be paid out of the 20% of the alpha, which could actually result in strong renumeration in good years. The best will survive and thrive, and clients will get both alpha and downside protection.
Some say this malaise faced by active is just nature’s way of making way for the robots – the algorithms and technology-based investors that we see more of every day.
Some feel this is already baked in…
If so, then why not at least influence what’s in that pie…