A New Era of Active Management Looms

The surge in popularity of passive investment strategies has been one of the most notable developments in markets since the financial crisis. This has led to frequent—and often intense—debate over the merits of active investing versus tracking an index. However, these discussions frequently ignore the context in which passive investment strategies have grown and the specific risks associated with them. As the global economy moves into the next phase, investors may be forced to reevaluate how they use passive investments—and what returns they can expect from them.

It is not difficult to understand why passive investments have become so popular. For one thing, they are relatively easy to manage—investing in a passive strategy does not require the same effort as researching, selecting, and monitoring good managers (and firing bad ones). In addition, the fees of passive investments are typically cheaper than those of active funds, although some large investors may negotiate fees on active mandates that are comparable to passive strategies. As passive strategies typically follow an index, underperformance risk is also lower than with active strategies. And perhaps most importantly, passive strategies have delivered strong performance over the past decade as asset prices have rallied since the financial crisis.

(Fig. 1) How QE Has Kept Markets Afloat
The performance of stocks and bonds over 20 years
January 1999 to October 2019

Even if more rounds of QE are announced, it is unlikely that interest rates on 10‑year bonds will fall by anything like the same degree that they have fallen since the financial crisis. When beta return is 10%, an alpha of 2% is nice to have, but not essential. When beta return is 5%, an additional 2% from alpha could be critical. In this environment, investors will face the choice of either accepting lower returns or adopting a different strategy in pursuit of similar returns.

As the impact of QE recedes, cross‑sectional volatility (the spread of performance between different sectors and securities) is also likely to return. When markets are flooded with central bank money, most assets are lifted, and selectivity becomes less important as investors can effectively “buy” the market and enjoy the ride upward. When markets return to more normal conditions, dispersion between sectors and securities is likely to reappear, bringing opportunities for a good asset manager to select outperforming investments and underweight lagging investments. At the extreme, when all securities move in the same direction, active management cannot add value; on the other hand, when returns of securities diverge active management can add value. We are likely to be heading into an environment where active management is not only important, but also has more opportunities to add value.

Passive investment strategies can make it more difficult to be on the right side of disruptive change. Kodak, Nokia, Xerox, Blockbuster, and Yahoo were all giants in their respective fields that failed to identify disruptive forces and lost. Today, the biggest firms are digital companies such as Apple and Amazon. These names may, of course, continue to perform well over the next decade and beyond, but relying on them to do so is an active bet, not a passive one—and it is important that investors are aware of this. A good active manager, with a keen sensitivity to change and disruption, could actively tilt the portfolio not only to avoid disrupted firms, but also to benefit from the disruptors.

Passive bond strategies are arguably even more vulnerable. The Bloomberg Barclays Global Aggregate Bond Index weights issuers by the amount of debt they issue, meaning that any passive strategy tracking the index will be overweighting the most indebted issuers. And while it may not be a problem to have an approximately 40% allocation to U.S. government debt, holding around a 16% weighting in Japan is likely to carry more risk, as is an overweight allocation to Italian government bonds.

This is neither to suggest that it is “wrong” to invest in passive strategies nor to suggest that passive investments will not have a role to play in the future. Passive strategies will very likely continue to perform an important function in investor portfolios, albeit in a different way than in the recent past. It is often suggested, for example, that passive strategies should form the core of a portfolio, with active investments used as “satellite” investments. In the future, the opposite may be the case: Active strategies may be used to make the core of the portfolio work as hard as possible, while passive strategies could be used primarily for thematic satellite investments. The active core is unlikely to be changed too frequently—allowing managers to benefit from a long investment horizon and minimize disruption due to cash flows—while the thematic satellite allocations may be swapped on a more regular basis.

These developments will become clearer over the next few years. In the meantime, investors seeking to position themselves for the period ahead may benefit from at least reexamining the role that passive strategies have in their portfolios as the impact of central bank stimulus fades—and consider how active strategies may be deployed more effectively to help them continue to generate strong returns in the future.