The majority of global pension plans believe the rise of passive investment funds is a foundational change in how they now manage their portfolios, recognizing that both active and passive allocations are necessary, according to a 2018 survey by British firm CREATE-Research.

Faced with this trend, the financial services industry must demonstrate the benefits of an active strategy, according to a 2017 report by the World Bank. “The rise to prominence of passive investment management, and increased flows of both retail and institutional assets into market-tracking vehicles, is likely to lead to an ongoing onus on investors who employ active management to show an incremental payoff from the additional costs associated with an active approach,” noted the report.

“While the scale, in-house teams and patient capital of Canadian pension funds enable them to deliver active management much more cost-effectively than plans serving the retail market, Canadian pension funds are not immune to the ongoing active-versus-passive debate.”

As more pension plans move into passive investment, what challenges do they face? And how does this strategy measure up against active management?

Fees, fees, fees

One of the main reasons for the growth of passive investments is investors’ increased focus on the relationship between returns and fees, according to Peter Lindley, the Canadian president and head of investments for State Street Global Advisors Ltd. “I think there is quite a bit more transparency these days than there once was, and people are realizing that it’s not that easy to constantly pick managers that add added alpha over time, especially on an after-fees basis,” he says.

When Blair Richards, chief executive officer of the Halifax Port ILA/HEA pension plan, took the helm more than two decades ago, the first thing he did was go passive on the fund’s fixed-income allocation.

Returns from that segment of the portfolio had been hovering very closely over the mean, so he wondered why the fund was ponying up for active management fees. “When I asked [the managers] about it, they smiled wryly and said, ‘Well, we’re really equity guys, that’s not where we’re going to take our bets, which was an indirect way of saying they were closet indexers,” he says.

Fast-forwarding to today, the anticipated returns from a passive fixed-income portfolio aren’t appropriate for meeting the fund’s needs as they stand, says Richards. “That led to all kinds of changes, including heading into the alternatives space, where we hadn’t been, and geographic expansion. But it also meant that where we were going to retain a weighting in fixed income, we felt only skilled managers could get us anything by way of alpha in excess of passive indexes. So we actually went active again after all this time.”

Performance issues

Research shows that, over an extended period of time, passive funds can perform just as well, if not better, than active ones, says Scott Anderson, regional vice-president of employee benefits at Hub International Ltd. However, a major market downturn could push performance in the opposite direction, he adds. According to CREATE-Research’s survey, about half (55 per cent) of global pension plans said they believe passive funds, which are currently buoyed by inflows, will be tested by an inevitable market correction.

Any reference to the lengthiness of the current North American bull market is clichéd, but it’s worth considering whether the lack of any real downturn for close to a decade has resulted in investor complacency about how well passive strategies can perform.

“We’re in the early stages of a risk-off cycle,” says Keith Reading, director of research at Morguard Corp. “Investors, although they’ve fared well over the past decade, I think, will probably look to take some money off the table and retreat to, perhaps, an increased cash position just to ride out this period, where we think we may be on the edge of a cliff.”

More than half (54 per cent) of pension plans that responded to CREATE-Research’s survey said passive funds have benefited significantly from central banks’ ultra-loose monetary policies, creating an environment where active managers have to prove their value-add to an even greater degree.

A serious swing downward for equity markets is looking less distant, with North American markets shedding hundreds of points on a given day with more regularity. As well, the bond market could become more challenging as interest rates begin to rise after declining for decades, says Joseph Connolly, an associate at Morneau Shepell Asset and Risk Management Inc.

While investors in both bonds and equities through passive vehicles should be considering what actions to take in this environment, he says a concrete reason for choosing either passive or active is integral to surviving unfavourable conditions.

Passive challenges

It’s important to note that index investing, a common passive strategy that invests along a particular index, is limited to certain asset classes, since alternatives like infrastructure, private debt and real estate don’t actually exist within an index an investor can attempt to replicate, says Connolly.

“The trend overall in a lot of the asset classes is a move towards alternatives and real estate . . . and it’s virtually impossible to replicate any two privately held investments,” says Connolly. “They’re never identical. So any index that is created is not going to allow you to compare your holdings, and that’s a challenge.

“If we say there is this trend towards alternatives and real estate, then implicitly we’re saying there is a trend towards active management in those areas, until the market somehow comes up with an index or a passive approach to invest in those asset classes.”

As well, investing by following an index inevitably means exposure to a broad range of companies, many with divergent reputations where environmental, social and governance issues are concerned. In the wake of the school shooting in Parkland, Fla., in March 2018, BlackRock Inc. created exchange-traded funds that excluded controversial companies such as firearms makers and retailers.

Firms that build index vehicles, like BlackRock, are making more of a show of their engagement practices lately, says Connolly. “The one thing the index firms are saying is that they are becoming more active proxy voters, so there is somewhat of a consciousness there.”

More ambiguous than funds invested in weapons making is the ownership of stock in Canada’s cannabis industry. As the country begins to deal with the legalization of recreational marijuana, U.S. Customs and Border Protection rattled many Canadians when it released a statement in September 2018 saying investors in cannabis businesses in Canada could have trouble being admitted into the U.S.

Soon after, the agency backpedaled, but the incident left some wondering how a policy could be enforced when virtually anyone investing along the TSX/S&P 500 composite index would have to be an owner of at least one cannabis company, Canopy Growth Inc., which reached a market capitalization of close to $17 billion in the third quarter of 2018.

Overall, investors remain cautious in denoting how impactful they want their investments to be, says Connolly. “If we draw a line in the sand, then we can say, ‘Well, look at government bonds. They invest in lottery tickets, alcohol, all kinds of things, that some plans may not find appropriate, but would you not invest in Canadian bonds? Of course not.”

Crying wolf?

Another consideration for institutional investors is that the move towards passive has raised more macro worries. One concern is that investors can’t move into more passive investments indefinitely because a healthy market can’t exist without those participants who actively conduct analysis to ensure there’s real reasoning behind why assets cost what they do. Passive managers, by definition, don’t actively engage in that analysis, so their increasing presence as market participants could weaken the amount of tangible information behind a given stock price, according to a March 2018 review by the Bank for International Settlements. This, in turn, could theoretically contribute to pricing inefficiency and the misallocation of capital, it added.

“You have to decide what group you want to be,” says Daniel Brosseau, director at Letko, Brosseau & Associates Inc. “Do I want to be part of the group that is doing the work, trying to reflect knowledge in prices? Or do I want to be part of the group that says, ‘Well, the other guys are doing a pretty good job and I’ll just go along for the ride?’”

Brosseau favours active strategies, noting his decisions as an influencer in the market are amplified the more people choose to participate passively. “Even though it may be a difficult task to try to understand the world, and to buy and sell things as a reflection of what you’ve come to understand about the world . . . . it’s better,” he says. “And if there are more people relying on, say, me doing that, then the greater advantage I think I have.”

While it’s purely theoretical that the majority of market participants will eventually become passive, John Bogle, founder of the Vanguard Group, has previously said that if everyone were to simply pile into index funds, markets would fail. It remains unclear exactly how many investors would need to use only index funds for this concept to become a real problem, but beyond 75 per cent would be seriously dangerous, he told Yahoo Finance in May 2017.

Looking at how investment decisions have been made historically, the research investors put into better understanding the value of potential investments is critical to the market functioning as intended, says Reading. “I think that there really is a risk that you lose those people, and if there’s a point at which you can’t explain what’s going on and then you’re unable to build value through these models, then what are you left with?”

However, Lindley notes investors probably don’t need to worry too much since this disaster scenario would require an enormous amount of homogeneity in the markets. “I think there’s a little bit of fear-mongering that’s going on, mostly by active managers who are trying to make that point. If I look at the Canadian market, the vast majority of equity assets are still managed actively.”

This article originally appeared on CIR’s companion site, Benefitscanada.com. Read the full story here.