Active vs. Passive
Ask A CIO #37
Active equity investing is famously a losing battle against the formidable index, yet institutional investors still invest in active equity investors. The main question is: why? Do CIOs have conviction that top active investors will still provide alpha over the long-term? Do they value the relationships and networks that these active investors provide? And at what point (and in what areas) should institutional investors look to passive indexing for equity exposure?
When it comes to equities, active versus passive is still a hotly debated topic among institutional investors, and there isn’t universal consensus. But you’re right, there are many institutions that have remained committed to active equity managers (though the number is probably smaller today than it was 10 years ago).
We’ve all seen the comparisons. The past decade has not been easy for active equity managers. Per Morningstar, just 20% of actively managed U.S. large cap funds survived and beat the average passive fund over the 10-year period.1 And frankly, that’s higher than I would have guessed. Active small cap equity managers fared better, with 38% of funds surviving and outperforming their passive competitors over the same time period.2
It’s easy to be cynical about active equity management. With average fees of over 1%, actively managed funds have a sizable hurdle to overcome just to match the benchmark, much less consistently beat the benchmark.3 Which means there are a lot of analysts and portfolio managers getting paid with not much to show for it.
And depending on who you talk to among institutional investors, their fee burdens for active long-only equity managers may have been even higher. After all, there are a subset of long-only equity funds, often associated with well-known hedge funds, that charge both management and incentive fees. (More on this later.)
All that said, I think there are still cases to be made for active equity management. Just not in every market.
By and large, the more efficient the market, the harder it is for active managers to generate excess returns over the benchmark. After all, active stock selection is about finding companies whose stock prices are undervalued, or mispriced, relative to what an investor believes to be the company’s intrinsic value or future value. In a heavily researched market, like that of U.S. large cap companies, informational advantages are harder to come by.
Conversely, in less efficient markets, differentiated research can yield informational advantages, and active managers might more easily find mispriced securities. Which makes intuitive sense.
I suspect that if you had transparency into every institution’s portfolio, you’d find that most of the active equity managers are specialist managers operating in less efficient markets. These include international markets, particularly emerging markets. They probably include markets that can be technically challenging to research, such as life sciences. And they might include certain sector-focused markets, such as energy or financials.
In these markets, I think the answer to your question is yes – investors have conviction that their managers will outperform market benchmarks. If an investor is going to be in these markets, then investing through active managers, in my view, is almost certainly the right decision.4
But the other question, which you didn’t ask, is whether investors should allocate dedicated capital to those markets at all? That question is where I think investment opinions will vary more widely. To the extent that institutions are debating active versus passive, they’re also debating the merit of investing in these narrower markets.
Now, back to the point I made earlier about those higher fee managers, the ones that have the audacity to charge incentive allocations for long-only strategies. These long-only funds generally (but not always) reflect harder to execute strategies. This category includes activist managers, crossover managers investing in public and private companies, and certain emerging markets managers. Same as above, institutions invest because they believe that the manager has a repeatable process and ongoing ability to outperform.5
Regardless of your opinion on active versus passive today, I would encourage keeping an open mind. I do think there’s a fine line between being principled and being dogmatic. Market regimes tend not to stay static, and what looks obvious and correct today may not look so in 10 years’ time.
Thanks for joining, and as always, reach out with questions: askacio@ivyinvest.co!
Until next week,
Wendy
Active vs. Passive Funds: Performance, Fund Flows, Fees | Morningstar (Updated September 23, 2024)
Active vs. Passive Funds: Performance, Fund Flows, Fees | Morningstar (Updated September 23, 2024)
I used Morningstar data as a proxy for active managers, but institutional investors are often investing in managers and funds that aren’t picked up in that dataset.
Some institutions take a hard line on fee structures, others focus on net returns.