Blog written by Fund Managers John Husselbee and Paul Kim
Neil Woodford’s troubles continue to cast a long shadow across the investment industry, giving fresh fuel to the increasingly strong pro-passive lobby.
Masses of comment on the ins and outs of Woodford are available elsewhere; for me, however, what is more interesting and potentially longer-lasting is how this situation has laid bare – but hopefully not calcified – prevailing attitudes to active and passive investing.
If you look at the comments under any of the Woodford stories published in recent weeks, among plenty of well-reasoned arguments there are also two clear tropes, often employed in tandem. The first dismisses Woodford – and all active managers in one fell swoop – as nothing more than a ‘coin tosser’; the second – in increasingly exalting terms – talks up the benefits of a passive investment strategy.
For me, both betray a fundamental misunderstanding of active and passive investment. And while there may be a few advocates of Eugene Fama’s market efficiency theory among these commenters, I would suggest it more likely shows the marketing effort of the passive industry paying off.
Against such a background, we continue to reiterate a couple of core messages about passive investing. First, we feel the whole notion of an active versus passive debate is outdated and reductive to both sides, largely propagated by those who benefit from framing the situation as an either/or when most professional investors use both. Second, while we continue to believe passives can offer adequate returns compared with a chosen index in the short to medium term, investors seeking outperformance over the long-term will need exposure to active managers.
In our portfolios, the starting point is passive: when investing in an asset class, we identify the availability and suitability of tracker options first and then look at whether it is worth paying extra for active managers. In some asset classes like smaller companies or high yield bonds, it is difficult to find passives.
For professional investors with the time and skill to filter the market like us, I continue to believe it is possible to develop a process to identify successful active managers – as long as you are patient. I understand some of the frustrations post-Woodford but dismissing the whole active management industry as coin tossing is ludicrous.
Our view has always been that no manager can produce market-beating returns every year but while consistency of performance is not possible, consistency of process very much is and forms a key part of our fund selection. Our estimates show that the very best active managers, if you have the time and patience to find them, will beat the market in six out of every 10 years on average.
As for the passive lobby, something which seems to have been forgotten is that the last decade of ETF ascendancy has come against a background of largely rising markets. But as the latter part of 2018 served to remind us, markets can very much go down as well as up and there is nowhere to hide when you are tracking a falling index.
With passive investing far more developed in the US than Europe, it was no surprise to find plenty of debate around the subject when I attended the Morningstar Investment Conference in Chicago last month.
In the US, passive market share has reached 45% and I was surprised to learn this figure is even higher in Asia, largely due to the fact the Japanese government bought trackers as part of its quantitative easing activity in recent years. Europe, as we all know, remains behind in this part of the market and lacks the tax advantages that have boosted passive take up in the US.
Without wanting to criticise the ETF space unduly, it is worth highlighting a couple of developments in recent months – as a counter to the relentless flag waving from many investors if nothing else.
Figures announced at the Morningstar Conference estimated there are a staggering 3.3 million passive funds around the world, 70 times more than the number of globally listed equity and debt securities. Morningstar analysts say three quarters of these work with one of three major index providers, which has led to some poor pricing behaviour in this part of the market.
Investors are fighting back, however, working with other data sources to provide generic indices that replicate the characteristics of well-known market benchmarks. For me, this is akin to supermarkets offering own-brand paracetamols and it remains to be seen how this this ‘self-indexing’ trend might impact pricing in a sector already known for its race to the bottom tendencies.
On this pricing question, I would also draw attention to recent news that the SEC has greenlit Salt Financial’s plans to launch the first negative-fee ETF in the US. Under this structure, the group will waive its entire 0.29% fee on the recently launched Salt Low truBeta US Market ETF and also contribute an additional 0.05% to the fund for the first $100 million in assets invested for the next 12 months.
Salt Financial said it is using the price incentive to grow asset levels to ‘meet arbitrary thresholds for inclusion on brokerage and advisory platforms’. This comes after Fidelity also launched a range of ETFs with zero fees in the US last August.
Experts suggest we are unlikely to see such developments in the UK for a couple of reasons – policy differences on the proceeds of stock lending and the much smaller size of our market– but I would ask questions of an industry where companies are having to give their products away to achieve the scale required to compete.
As stated, we continue to use passive funds in our portfolios and see many benefits of cheap beta in the short term. But the growing number of passive-only advocates should not be allowed to go unchallenged just because a few active managers have left the industry open to criticism.