Battling the bulls – the false clash of active and passive investors

Battling the bulls – the false clash of active and passive investors

LOcom_AuthorsLO-Monier.png   By Stéphane Monier
Chief Investment Officer
Lombard Odier Private Bank

Investing today is often pitched as a battle: stuffy fund managers versus cutting-edge exchange-traded funds. But oversimplifying the divide between ‘active’ and ‘passive’ does not help investors. Instead, we must look at the costs, risks and opportunities of each. At Lombard Odier, we believe in a pragmatic investment approach, challenging the labels and conventional wisdom on when to use active and passive solutions. What matters to us is generating the best risk-adjusted performance after fees for our clients.

Passive – paying less for more?

Since the rise of ‘passive investing’ via liquid exchange-traded funds in the early 2000’s, the traditional fund manager has become viewed as old-fashioned, even redundant, and active fund management an industry conspiracy to tap clients for high fees. Passive investment solutions, in the form of index-tracking funds, are seen as analogous to Uber’s disruption of taxi services, or music streaming killing CDs. Since the global financial crisis (GFC) of 2007-2008, when equity index trackers have often produced 7-8% returns, investors could be forgiven for thinking that active fund managers are playing a futile game of trying to outguess the market, with investors paying on average 1.4% of their portfolio every year for a roll of a dice.

Instead, the rhetoric goes, a low-cost revolution is underway. The average expense ratio for a passive equity fund is around 0.6%, less than half the 1.4% for an actively managed equivalent, according to Thomson Reuters Lipper data1. In the last decade, over USD1 trillion is estimated to have flowed from active funds to passive solutions2. By January 2018, more than half of managed equity assets in the US will be in passive funds, according to brokerage firm Sanford Bernstein. For global equities, their estimate is 38%.

Passive investment enthusiasts point to common sense and research to back their arguments. In today’s markets, so the logic goes, a highly efficient global information network minimises asset pricing errors: the internet and regulators ensure stock-sensitive information is made simultaneously available to all investors. In such an environment, what value can active investors add? Those that outperform in certain years fail to adjust their management style (eg switching from ‘value’ to ‘growth’) for new market conditions, and so underperform in a new era. A 2016 study by S&P Dow Jones Indices showed that about 90 percent of active stock managers failed to beat their index targets over the previous one-year, five-year and 10-year periods, with fees explaining a significant part of the underperformance3.

Active – intelligent investing?

Naturally, active investors cite some strong arguments for a different approach. The period since the GFC has been unusual in that the largest stocks in the largest, most liquid market (the US) have outperformed. Between 2000-2008, the inverse was often true – with small cap stocks and many active managers posting strong returns. 

Over the long term, they say, would you rather select the companies you invest in based on their leadership, balance sheet, products and services, or purely by their index weight? Passive investing can misallocate capital – exposure to stocks based on their market capitalisation, rather than the most deserving ones. Large volumes of money flowing into an index can create less efficient markets, where company valuations are overlooked. Governance takes a back-seat. In such a world, who will analyse and reward true innovation at individual firms, or question a company’s ethics or its executive pay? As investors seek to align their asset allocation more with their values, active managers have the upper hand in advising on socially responsible and impact investing.

Some active investors have gone further, calling passive investments “weapons of mass destruction4” which have caused an asset price bubble. Huge flows into exchange-traded funds (ETFs) in recent years have distorted stock prices, they argue. Returns reflect multiple expansion more than profit growth. ETF flows have created markets divorced from underlying fundamentals, that move in lock-step. Large-cap stocks have become overvalued, systemic risk has risen and markets are more vulnerable to sell-offs. This new world, dominated by vast ‘blind’ flows in and out of liquid investments, has not been tested in a major downturn.

Debunking the myths

We disagree with this clash between ‘active’ and ‘passive investing. The investment world is not black and white. Oversimplifying is dangerous, and worse, the following, oft-cited arguments can mislead investors:

Passive investments are simple tools. ‘What could be simpler than tracking an index?’ one might think. Investors often fail to analyse passive investments in the same way as they would active ones, but those seeking to understand how an ETF tracks an illiquid index will find layers of complexity under the bonnet. ‘Physical’ ETFs own a basket of investments that replicate the index. ‘Synthetic’ ETFs replicate the index by using a financial derivative (swap), paying swap fees in exchange for receiving index-like returns. Both require complex management to ensure returns track the index as closely as possible. 

Meanwhile, investors that regard index-tracking as a simple portfolio-building solution often forget a very basic question: does the index actually suit their needs? An index is defined by a set of rules with no reference to an investor’s constraints, goals or risk appetite; many are not built for the purpose of maximising risk-adjusted returns. A passive investment might beat an index, but still fail to fulfil an investor’s objectives. And no ETF can replicate a private bank’s expertise in tailoring individual client solutions and generating efficient post-tax returns.

Passive investments are all low-risk, with transparent costs. Index-trackers have undeniably embraced technology to produce a wide range of low-cost, scalable investments. Many are extremely efficient, highly liquid and easily tradable tools. Yet their true structure, risks and costs are sometimes hard for investors to grasp. In physical ETFs, the underlying securities may be loaned out to generate extra revenues that lower the end cost of the investment. In synthetic ETFs, the counterparty might do this, generating ‘swap enhancement’ that performs a similar function. Both actions could potentially cause investors to lose their capital in a crisis.

And the ‘total expense ratio’ (TER) typically cited for the cost of an active investment does not paint the whole picture for an ETF. As well as the management fees reflected in the TER, ETF investors are also charged trading and brokerage fees on top of transaction costs for physical ETFs (and swap fees for synthetic ETFs) which are not typically disclosed in fund factsheets. These reduce the investment’s performance. Transaction costs can mount up if the basket deviates from the index’s net asset value. Total fees for a physical ETF reached 93 basis points (bps) in one example we calculated (versus a 20bps TER), and 132 basis points for a synthetic ETF (versus a 68bps TER).

Taking a pragmatic approach

Many investment providers recommend passive solutions as a convenience, because they lack the resources to advise otherwise. We have built substantial in-house investment capabilities, because we believe our proprietary research and expertise adds value for our clients and gives us the freedom to recommend either an active or a passive approach. Our priority is generating the best risk-adjusted returns, net of all fees, with no pre-set preferences for either. Typically, we blend both solutions, often in ways that counter traditional thinking.

Fixed income – a specialist approach. Existing, market-cap weighted bond indices typically favour the most indebted borrowers, so we recommend investors follow our own benchmarks, weighted towards better-quality issuers with a similar sector and geographical exposure. Alternatively, we recommend active approaches. Fixed income markets are heavily influenced by players like central banks, pension funds, sovereign wealth funds and insurers, whose primary objective is not to generate excess returns, leaving plenty of opportunity for active investors to exploit market inefficiencies.

Equity investing –a contrarian view. We use active funds to invest in companies with strong fundamentals, and passive approaches to tap into underlying market performance. If the economic cycle is young, we may seek passive exposure without favouring individual sectors or securities. By contrast, in today’s mature US markets, we may use active equity funds to segregate ‘winners’ from ‘losers’, reflecting the dominance of technology firms like Apple and Facebook, and capturing the performance of small-cap firms not included in major indices. This runs counter to the conventional approach of using index trackers for large ‘efficient’ markets.

Taking stock of market distortions, and a world of ‘massive passive’. The rise of passive investing has coincided with an era of unprecedented central bank interventions. Following the GFC, ultra-low interest rates and asset purchase programmes have artificially lowered the cost of capital, thrown weak companies lifelines, rewarded indebtedness and glossed over poor investment decisions. A low-yield world has created high premiums for dividend-paying stocks. The inability of active investors to outperform has created a self-fulfilling momentum trade: leading more people into index trackers, pushing up cross-sectional correlations and driving down stock dispersion. Now that central banks are unwinding these programmes, we believe correlations between asset prices should decline, increasing opportunities for active managers.

If we accept that flows from active into passive investments have changed markets, then the cyclical ‘normalisation’ of such distortions could in future provide a great opportunity for active investors. If the rise of ETFs continues, there will be fewer of them than ever to exploit pricing errors. The next big market correction could see purely passive investors lose out the most.

1 Source: Thomson Reuters Lipper fund data, August 2016
2 Investment Company Institute Factbook 2017; outflows from actively managed domestic equity funds, January 2007 – December 2016
3 S&P Dow Jones Indices, US Scorecard, Aye M Soe and Ryan Poirier, September 2016
4 Bloomberg, 27 April 2017 “ETFs Are Weapons of Mass Destruction, FPA Capital Managers say”



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