Today we are going to talk passives, and another look at some of the topics around investing in passive vehicles. We have all been inundated with headlines forecasting the death of active management and the steady march of passive investing over the last decade, but today I want to challenge some common perceptions, and ask whether the next decade will continue to see the growth in passives or whether a different environment might see a change in investor’s attitudes.
Recent years have been tough for active managers, with 2022 as difficult as any. Why is there any reason to think the next few years will be any different? There are a few factors which seem to be swinging in favour of active managers. Firstly, volatility is the active manager’s friend, and a number of measures are now looking more favourable. Some recent work by Howard Zhang of MSCI, which can be found on their website, shows that cross-sectional volatility, a measure of stock dispersion, is some way above the average in all major regions bar Japan. If there is a high level of dispersion, active investors can potentially identify and invest in undervalued stocks with strong potential for outperformance, while avoiding overvalued stocks, that may underperform. The last two times this measure was elevated, post the tech bubble at the start of the century and during the Global Financial Crisis in 2008-09, these were fruitful periods for active investors. I also saw similar results in analysis by JPMorgan, showing the spread of valuations between the cheapest and most expensive quintiles of stocks, where a wider spread implies greater opportunity to add value through stock selection. Again, this was well above the average, and likewise had only been seen at these levels in early 2000s and during the GFC.
The hurdle for active management is much lower than it ever has been to produce outperformance after fees, and that can only be helpful, whilst the differential with passives is falling. Ultimately the level of fees charged is one of the primary factors in outperformance long term. As I’ll talk about later, some passive vehicles are actually more expensive than active managers.
We may also be entering a period where the trends of the last decade are beginning to reverse. Performance has been dominated by a handful of growth stocks that also are the largest index constituents, with this especially prevalent in the US. With large passive inflows being directed more towards those largest index stocks, this was also arguably a factor exacerbating this trend. Lately we have seen a reverse, with other areas of the market coming to the fore. Value has been in favour for an extended period, whilst we might expect a period in which mid-caps outperform large-cap peers as we move through the economic cycle, with the former naturally a more fruitful hunting ground for active managers. Interestingly US active managers had a more positive 2022, very much due to these factors. For UK investors, the largest index constituents of our market are quite different, and that has been at the heart of a difficult 2022 for active UK investors.
One asset class that has particularly struggled has been global equity funds, where the challenge of outperforming the index has been particularly difficult, and results have been poor, and significantly weaker than regional funds. This is despite many investors moving away from a regional investing approach to a global approach, led by institutional investors, and also influenced by the move towards sustainable investing, where global funds are much more prevalent. The difficulty has in part been the enduring outperformance of the US, both in the underlying market and in the strength of the dollar. This is certainly a topic in itself, but I suspect a reversal of this dynamic would be quite a positive for many investing globally.
I should say at this point that we still very much believe that there is a role for passive funds in a balanced portfolio. That might be to gain specific exposure to particular parts of the market, or to ensure costs are appropriate and potentially allow higher cost alpha generators to be accommodated. Anecdotally UK investors have actually been a little more stubborn in adopting passives to the extent of the US or even Europe, although hard data on this is difficult to find. Perhaps this is in part because of a natural bias towards the UK market, which has been a fruitful area for active managers, with the particular recent exception of 2022.
In the second part of this podcast I want to touch on another issue we have found when investing in passives that may surprise some of you. In some areas it can be relatively hard to find the right vehicle at the right price, despite the substantial number of launches. Whilst there are now over US$15t in passive ETFs, as a UK investor we have found some anomalies. For example, with value outperforming growth more recently in the US, one might assume there are plenty of options tracking the US Russell 1000 value index, the most frequently quoted value index in the US. However, that is not the case, with just one European domiciled option, which appears to have a pretty high bid-ask spread at times, easily catching out investors who are unaware with much higher costs.
Last year Australia came to the fore as one of the leading markets, buoyed by exposure to banks and miners, and one of the few markets to register a positive return. Australia is somewhat of anomaly, along with Canada, in that it tends to be somewhat overlooked. Asia managers tend to bias more towards emerging Asia nations in the same way that more investors are focused on US rather than North America as a whole. However, if one did want to invest in a simple Australia ETF, the cheapest available is 40bps, nullifying one of the key benefits of going passive, namely cost. This is clearly a market pricing anomaly as broader Pacific or Asia ETFs can be bought at single digits, so it’s not a cheap option at all.
Let’s take the iShares MSCI Japan tracker, which would cost you 59bps total expense ratio (TER). However, you can buy the iShares MSCI Japan IMI for 15bps. The latter is of course a slightly different index, with MSCI Japan IMI including more small caps, but the pricing is anomalous. There are plenty of other examples we could highlight across the board where passives are now often more expensive than active managers, if you select the wrong option or remain in an expensive vehicle where cheaper options exist.
The active passive debate has long since moved past the question of either/or for most investors. However, the last decade has been a one-way trade in favour of passives. It happens to have coincided with other decade-long trends, namely persistently lower interest rates and a dominating style and region. My recent conversations with active managers have included increasingly positive views on the prospects of active management, albeit clearly highly self-serving.
Nonetheless, in the 21st century, the most fruitful period for active investors happened to occur post the tech bubble, and we can at least see some broad similarities. Of course, to some extent it is a nil-sum game, and however much the environment is more favourable to active investing, client results will still very much depend on active managers who have the right resources, investment discipline and, most likely, long-term time horizon to capture some of the factors we have talked about today. Plenty will still fail regardless. Nonetheless, now seems as promising an opportunity as any to do so.
This is a marketing communication and is not independent investment research. Financial Instruments referred to are not subject to a prohibition on dealing ahead of the dissemination of marketing communications. Any reference to any securities or instruments is not a personal recommendation and it should not be regarded as a solicitation or an offer to buy or sell any securities or instruments mentioned in it.
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