Active management under scrutiny. Closet indexing, underperformance and high fees continue to erode investor confidence.
Introduction
In the ever-evolving world of finance, few topics spark as much debate as the merits of active versus passive investment management. As passive strategies continue to gain market share1, a pressing question emerges. Is active management still truly active?
This article delves into the nuances of modern active management, exploring its challenges, adaptations and future in an increasingly passive-dominated landscape.
The active management conundrum
Active management, at its core, is about making informed, strategic decisions to outperform market benchmarks. However, the increasing prevalence of ‘closet indexing’ complicates this narrative. Closet indexing not only undermines the trust that investors place in active managers but also raises important questions about the ethical implications of such practices. Investors expect active management to involve rigorous research, timely decision-making, and a distinctive investment approach.
A 2015 study2 by Martijn Cremers and Quinn Curtis found that approximately 20% of mutual fund assets were invested in closet index funds. This startling figure underscores the need for investors to scrutinise their ‘active’ investments carefully.
Measuring true active management
To address the issue of closet indexing and quantify the degree of active management,
researchers have developed metrics such as ‘active share.’
Introduced by Martijn Cremers and Antti Petajisto in 20093, active share measures the percentage of a portfolio’s holdings that differ from its benchmark index. For US equity mutual funds, a truly active fund typically has an active share of 80% or higher, while anything below 60% might be considered closet indexing. While ‘active share’ is a useful tool, it is crucial to understand that it is not a standalone measure of a fund’s potential to outperform. Funds with high active shares might still underperform due to poor stock selection or inadequate risk management.
Investors should consider active share in conjunction with other metrics, such as tracking error, which measures the volatility of returns relative to a benchmark. Additionally, analysing risk-adjusted returns through metrics such as the Sharpe and Information ratios can provide a more comprehensive understanding of whether the fund is delivering value for the level of risk taken. For example, the latest Alexforbes International Survey4 shows that only 29% (12 out of 42 funds) of the global active equity funds produced a positive Information ratio over the three years ended 31 July 2024.
The performance puzzle
The ultimate question for investors is whether active management delivers superior returns. The evidence is mixed and often depends on the TIME FRAME and MARKET CONDITIONS examined. According to AJ Bell’s 2023 Manager versus Machine report5, only 22% of active global equity funds beat the average index tracker over the past decade.
It has become more challenging for global equity funds to outperform because we know that developed markets are more efficient – see the section below on the paradox of skill – and only skilled managers have demonstrated the ability to consistently outperform their benchmarks over long periods. This high percentage of underperformance should be an eye opener for local investors now that pension plans can invest up to 45% offshore and individuals increasingly use their offshore allowances to gain expose to global markets.
At the same time, there are market segments and conditions where active management has shown a greater potential to outperform. These often include:
The challenge for investors lies in identifying these skilled managers in advance.
The fee debate
The discussion around fees often centres on the idea that higher fees are justified by the promise of superior performance. In
response, some active managers adopt performance-based fee structures, where fees are tied to a fund’s ability to outperform its benchmark. This somewhat aligns the interests of managers and investors, providing a more compelling case for the value of active management.
Active funds typically charge higher fees than their passive counterparts, justified by the additional research, analysis, and portfolio management required. However, these higher fees create a performance hurdle that active managers need to overcome.
The key question for investors is whether the potential for outperformance justifies the higher fees. This calculation should consider not only the possibility of higher returns but also factors such as risk management, downside protection, and the potential for alpha generation in specific market conditions.
Market efficiency
The rise of passive investing has transformed the asset management industry, leading to concerns about market efficiency. As passive funds grow in size and influence, their investment decisions are driven by index compositions rather than fundamental analysis. This could potentially lead to mispricings and market distortions, which skilled active managers might exploit.
However, as markets become more efficient due to the widespread availability of information, the challenge for active managers intensifies. The ‘paradox of skill’ highlights that as the average skill level of market participants increases, the gap between the ‘very best’ and ‘the average’ manager shrinks and excellence becomes more uniform. In almost all sports, the difference between the best player and the median player has dropped, owing to what has been called the paradox of skill.
Essentially, as all athletes get better at their sport, the difference between the best player and the average player decreases. In any competitive endeavour that involves both luck and skill, as the difference between the top competitor and the median competitor declines, skill becomes less important and the role of luck increases. Hence, it becomes harder for any individual manager to consistently outperform as the ‘available alpha’ appears to be shrinking, making the differentiation between luck and skill more difficult. In fact, the active managers that are ‘left at the table’ are the smartest managers but the role as an active manager just got a lot more difficult.
The evolution
Furthermore, the growing importance of ESG – Environmental, Social, and Governance – criteria offers fertile ground for active managers to demonstrate their ability to integrate non-financial factors into their investment processes. Thematic investing, which targets specific long-term trends such as climate change or technological innovation, also represents a growing area of interest, providing active managers with new avenues to generate alpha.
Adapt or die…active management
The future of active management lies in its ability to adapt to the changing landscape. While passive investing has gained significant ground, active management remains crucial in areas where human judgement and strategic decision-making are paramount. Private markets and alternative investments, which are less accessible to passive strategies, offer significant growth potential for active managers. These areas require specialised knowledge and the ability to navigate complex investment environments, which are well-suited to active management.
Moreover, the increasing demand for customised solutions, particularly among institutional investors, underscores the ongoing relevance of active management. These solutions often involve dynamic risk management and tactical asset allocation, areas where active managers can add significant value.
As the industry evolves, transparency will be crucial. Investors are demanding clearer information about investment processes, fees, and how value is being added. Active managers that can effectively communicate their strategies and demonstrate consistent value creation will be better positioned to attract and retain assets.
Conclusion – a nuanced perspective
The question of whether active is active or not, does not have a simple answer. The reality is that the asset management industry encompasses a spectrum of strategies, from pure indexing to highly active approaches and everything in between.
There is no doubt that active management faces significant challenges but it also continues to evolve and adapt. As passive strategies gain market share, managers that are truly active may find new opportunities to differentiate themselves. The future of asset management is likely to be one where active and passive strategies coexist, each playing an important role in building diversified and efficient portfolios.
In this complex landscape, the most successful investors will be those who can critically evaluate both active and passive options, understanding the strengths, limitations, and appropriate applications of each approach and whether it aligns with their investment objectives to meet their goals. The debate between active and passive is far from over, and the next chapter in this ongoing saga promises to be as fascinating – it is important for the future of finance.