This article was originally published by Project Syndicate
Discussions about the merits of active versus passive are not isolated to end investors. Those involved in the construction of portfolios have also engaged. Increasingly, they view ‘active versus passive’ as a sideshow. Paraphrasing President Nixon, ‘we’re all active now’. The discussion has shifted to how active decisions should guide portfolio management.
Recognising that fact is critical, as it shifts attention to what matters most, namely the strategic asset allocation decision.
Since 2003 the assets of global exchange traded funds (ETFs) have grown from about USD 200 billion to nearly USD 4.5 trillion last year1 . ‘Passives’ have the upper hand, with active ceding market share.
Naturally, investors should take the lower cost option if paying up brings little additional value. That’s especially likely during bull markets, when outsized returns can be achieved simply by being in the market.
Yet the explosive growth of low-cost investing had two additional and important impacts on investment management.
First, the rise of ETFs put active management fees under pressure, particularly where active performance lagged. The proportion of hedge fund managers currently charging ‘two and twenty’ has now dropped below a third2. Given the past decade of mediocre hedge fund performance and the advent of liquid alternatives, it’s surprising that fees haven’t fallen more.
Fees are declining elsewhere as well. Average active fees across all strategies fell from about 1 per cent in 2000 to .72 per cent in 20173, a downward trend that shows no signs of abating.
Second, as ETF issuance mushroomed, the distinction between ‘passive’ and ‘low cost’ blurred. Properly defined, a passive strategy is one that is continuously re-balanced to track the market capitalisation weighted index. Yet the explosion of ETFs has gone well beyond the textbook definition of passive. ETFs for regions, sectors, factors, credit and a multitude of sub-market exposures have proliferated. They are not ‘passive’, but instruments to express active views inexpensively.
Several decades ago, the advent of cheaper instruments, including ETFs, could readily boost investor returns net of fees. From 1979 until 1992, for example, the average weighted retail mutual fund expense ratio was about 1.5% (includes sales load fee)4.
Today, however, the average fee on actively managed funds has dropped below 75 basis points versus an average of about 44 basis points for ETFs . The ‘excess return’ to ETFs5 is falling.
The rapid expansion of ETFs also coincided with bull markets, where index performance dominated security selection and where asset allocation meant little more than piling into stocks, bonds and credit.
Those days are probably over. We believe sustained market advances are unlikely, given stretched stock and bond valuations, slowing economic and earnings growth, as well as heightened political and policy uncertainty. Broad market returns are likely to be lower, with episodes of volatility probably more frequent.
This brings us back to strategic asset allocation, the decision which determines most of the variance of portfolio returns. Other factors, such as tactical asset allocation or instrument selection are secondary drivers and may account for less than 10% of portfolio variance.
In a world of lower returns and where the fee gap between active and ‘passive’ instruments is narrowing emphasis must shift from mere cheap market access to proper portfolio construction.
The biggest mistake investors could make is to seek haven in ‘balanced portfolios’ of stocks and bonds. Both asset classes suffer from poor valuations and deteriorating fundamentals. It beggars belief to think that holding both in roughly equal proportion will deliver satisfactory results. Cheap beta now means poor risk adjusted returns.
Investors must instead recognise that falling Sharpe ratios and shifting correlations place a premium on solutions that deliver genuine diversification and loss avoidance. In our view, diversification requires attention to market, factor and non-directional sources of return, alongside a focus on volatility and correlation. We believe loss avoidance requires flexible decision-making to cut exposures when conditions warrant.
Some of the instruments needed to deliver diversification and loss avoidance may well be low cost. But many, including long/short or alternative risk premium strategies, are unlikely to be found in the universe of ETFs. We believe a blended approach is likely to provide the greatest benefits of diversification.
The crucial point remains. When it comes to the most important decision in investment management, proper portfolio construction, we’re all active now.
(Copyright: Project Syndicate, 2019)