I apologize in advance to readers of this week’s column but, like a moth to the flame, I’m drawn to the bitter and ancient (in investment terms, at least) active versus passive debate. The reason I apologize is that I’m not entirely convinced this debate really advances the sum of human knowledge, if only because both sides seem to repeat their same arguments – perhaps now with a twist.
In previous decades, it was the passive side of the debate that seemed more disruptive, while the active fans were more ‘establishment,’ so to speak. In the bright sunshine of a new century, the tables are seemingly turned. Today, it’s the passive brigade who dominate the high towers of Big Finance and academia while the active proponents doggedly fight on what seems a bit like a rear-guard action.
As someone who generally believes in the supremacy of passive funds in many circumstances, I must declare an interest. But I also think that the picture is much more confusing than both sides maintain. Call me an investment moderate in an age of populist thinking, but I believe both active and passive management can make sense depending on the asset class or investment niche. I touched on this more nuanced position a few weeks ago in a column for Citywire Funds Insider which resulted in the table below. In short, the answer to ‘Active or passive?’ is: ‘It depends.’
My take on where to go active and passive
|Preference for active||Preference for passive|
|Asia ex-Japan equities||Global large- and mid-cap equities|
|Smaller companies||US equities|
|Japan equities||UK all-cap equities|
|Global frontier markets||Global emerging markets|
|Indian equities||China equities|
|Latin American equities||Single strategy bonds|
|Multi-strategy bonds||Style: dividend-weighted, equal weight and momentum|
|Absolute return||Lifecycle/target risk (purely cost consideration)|
|Style: quality and value||Commodities|
|Private equity||Diversified commodities (using systematic ETFs)|
|Venture capital||Most single equity sectors|
|Tech (although thematic tech ETFs are useful)|
That article, of course, prompted an inevitable series of emails and comments which basically asked ‘why’ – as in, why does it depend on the asset class? And, more importantly, why did I put each one where I did? One advisor questioned why I had put global emerging markets in the passive category, writing: ‘I thought that EM was the perfect example of an asset class that wasn’t great within an ETF. Lots of illiquid markets, lots of difficult-to-track stuff.’
One answer to this articulate question was to point to a story just weeks later which involved a leading UK fund manager throwing in the towel on their actively managed global emerging markets investment trust (a closed-end fund structure popular among UK active managers, and in effect a direct competitor to ETFs). You can read the full story of why Terry Smith of Fundsmith has closed his EM fund (ticker: FEET) here, but to summarize, the manager gave up because they didn’t have a ‘particular edge that would allow us to deliver superior risk -adjusted returns.’
But that advisor’s email kept bugging me. I felt I owed their question a more thought-through response, and so over the last few weeks I have been contemplating why passive funds sometimes have an edge in the emerging markets category. I’m sure there’s a mountain of detailed academic research we could point to, but what we really need is a more instinctual answer that can be communicated easily to end investors.
I would point to three key factors, two of which I think are obvious. The first is the question of liquidity. In a market where there is deep liquidity, there is a natural bias towards passive funds. Of course, the modern-day challenge is that more and more rewarding strategies gravitate towards illiquid, private funds, especially in private equity and venture capital. These markets can be made more liquid and transparent and thus adaptable to a passive format, but I doubt it will make much of a difference. Therefore, it would seem, active strategies (or active indices, at the very least) are poised to dominate.
Information asymmetry is the next obvious factor. Put simply, when the market has ‘dark spots’ where market participants can gain an active information edge, then we can expect active fund managers to outperform. Within this category I would also include the increasingly obvious point that ‘risk’ can be measured and acted upon differently; that is, some managers might have a better understanding of what constitutes risk in these markets.
So far, nothing too adventurous.
But I would add one last factor which brings us back to the decision by Fundsmith to pack up shop: system predictability. It’s all well and good to have an information edge built upon asymmetry of information flows, but that ‘edge’ is only useful if it’s replicable and predictable. And here, I think, is the crux of the issue – the nature of the system in which the market operates. Emerging countries are full of markets run by governments that are essentially unknowable and unpredictable, topped of course by everyone’s favorite, China, although the Indian government isn’t exactly renowned for its predictability either. This cuts to the core of the challenge for emerging markets investors, namely: How can they gain an edge in terms of information flows if the key players keep changing policies to serve their own ideological ends? The transparency of the system in which a market operates critically determines its predictability, and thus the ability of an active manager to develop ‘an edge,’ or an information advantage. I would argue that with this in mind, one is forced to concede the superiority of the passive fund model. And what’s true for emerging markets is also true for global commodity markets.
The good news for active fund managers is that there are still plenty of investment niches, strategies and asset classes where my three-point structure holds, not least the vast panoply of private market funds. There are even some public market classes, such as Japanese equities, small cap equities or even single-country emerging markets, where active managers can work their magic. But this leaves broad swathes of more liquid public markets firmly in the hands of passive fund managers. Here, we can see the emergence of a sensible compromise between the warring camps. Both active and passive can happily co-exist, although the firms likely to dominate the new active fund management heartland will probably look very different than they do now.