In the age old question of whether passive or active investing is the best course, a new paper from Mercer proposed a simple answer: it depends.
Specifically, it depends on what an investors’ goals and priorities actually are, the paper said.
The popularity of passive strategies can, in part, be attributed to their continued success. However, the paper noted some of the reasons for this success are coincidental. For example, since the financial crisis, active managers have been frustrated in their attempts to discern good investments from bad because the monetary policy taken on to deal with the crisis became a rising tide that lifted all boats. “Junk rode up on the tide of quantitative easing along with everything else,” the paper noted.
Notwithstanding, the move into passive strategies has been massive, for both equities and fixed income. In the last five years, Mercer’s European clients’ passively managed equity rose from 43 per cent to 52 per cent, and fixed income from 37 per cent to 51 per cent. The paper noted other research that found assets under management globally in indexed funds rose from US$619 billion in 2008 to US$3.4 trillion by the end of 2017.
If an institutional investor wants to succeed in active management, research is the key, the paper said. Finding the right managers is integral, as is exploiting under-researched segments of financial markets. “The U.S. large cap equity market is relatively efficient and difficult to make money in, whereas small cap is a more fertile hunting ground, as many stocks are under-researched, particularly with the regulatory pressure on sell-side analysis,” the paper said. “Emerging market stocks also benefit from lower analyst coverage, so proprietary research can add value; in addition, access to countries with high growth rates can lead to better opportunities for equities.”
In its analysis, Mercer found that a small pocket of asset managers have been able to deliver notable alpha over a lengthy period within the U.S. market. Those managers share characteristics like having a long-term time horizon and a high active share, meaning they’ve shown an increased willingness to deviate from the benchmark.
However, the paper noted that overconfidence can hurt investors taking the active route and they should be prepared to exercise a significant amount of governance. “If, as an investor, you employ active management, you must regularly reassess your own ability in hiring and firing managers and related governance processes,” the paper said. “Be prepared to both allocate a substantial proportion of your governance budget to it and make difficult and often counterintuitive decisions (for example, holding onto an underperforming mandate or terminating an outperforming one).”
Indeed, going active requires investors to reevaluate far more frequently, the paper said. It’s important to the original reasons for an investment in mind and to have a robust monitoring process. “Always keep in mind how the manager said it would perform, including the key risks outlined before you appointed the manager,” the paper said. “Monitor the manager against what it said it would do — which will often involve monitoring the manager in several areas, both quantitative and subjective.”
As well, investors shouldn’t neglect to factor in fees, it noted. When doing so, it’s important for the investor to be realistic about the expected returns from an active strategy. It’s safer to assume the returns will be lower than the fund’s performance target, the paper said, so fees should be considered accordingly.