What’s been happening and what’s on the horizon in the world of pensions
The long-running active-passive fund management debate will never be solved if its either/or framing, which incorrectly treats the two approaches as mutually exclusive, isn’t revised. The debate has also become skewed owing to the tendency to narrowly focus on cost rather than net value added. In this edition we revisit the pros and cons of each approach, with the notable inclusion of how each seeks to incorporate increasingly important environmental, social and governance risk factors into its methodology and examine why this further skews the debate.
The misframing of the active-passive decision
Next up is the tendency to approach the decision problem through a narrow cost, rather than a wider net value added, lens. Doing so has again resulted in a skewing of the debate, with many investors taking the line of least resistance and opting for a low-cost passive, or index tracking, solution. Rather, a focus on the ability to sustainably generate net value added – that is, delivering sustained superior risk-adjusted performance after fees while meeting desired investment outcomes and risk appetites – is how the active-passive decision should be approached.
Passive fund management
Passive management, or index tracking, involves constructing a portfolio of securities that replicates or tracks the total return of an equity index, on the premise that securities are efficiently priced. On the plus side, index tracking minimises the risk of underperforming the benchmark index before fees and the costs of investing by only transacting when necessary, such as when new money and investment income is received, to meet investor redemptions and accommodate periodic changes to the index being tracked. On the flip side, however, once fees, costs and a number of minor technical factors are taken into account, underperformance of the market often results. Moreover, being fully invested in the chosen index means trackers follow the market down as well as up.
Most equity index tracker funds are based on market capitalisation-weighted indices, such as the S&P 500 and FTSE All Share, where the largest stocks in the index by market value have the biggest influence on the index’s value. However, tracking market cap-weighted indices is not without its problems. Index trackers cannot be customised to meet all investor objectives and risk appetites –the index chosen is the index tracked. As we’ll see, this can be particularly problematic for investors seeking to integrate ESG risk factors into their portfolios. Also, diversification is often compromised by the index being highly concentrated in a few sectors – although the opposite extreme, overdiversification, is true when tracking more broadly based indices.
Far and away the biggest problem though, is that the largest positions in the index are concentrated in those sectors and stocks that the market perceives to be the most successful, even though these may transpire to be yesterday’s winners rather than today’s. Indeed, with rapid product innovation and lower barriers to entry for potential new entrants in many industries, industry pre-eminence can often be a temporary phenomenon. Moreover, the resultant misallocation of capital and subsequent drag on performance is particularly acute in momentum-driven equity bull markets. This is because market cap-weighted index trackers are forced to allocate more money to what prove to be increasingly overpriced market favourites and less to those sectors and stocks likely to be undervalued.
Active fund management
By contrast, the basic premise of active management is that markets are inefficiently priced. That is, securities are not correctly priced, at least not in all markets and not all of the time. Therefore, active managers seek to profitably exploit these mispricing opportunities by taking positions in stocks different to their weight in the index or in off-benchmark positions not represented in the benchmark they seek to outperform. In so doing, actively managed funds address many of the criticisms levelled at index trackers.
Firstly, they can be positioned to meet stipulated investor objectives, risk appetites and defined outcomes. Indeed, investors are increasingly looking for asset managers that can deliver defined outcome-based investment solutions, increasingly with ESG risk factors fully integrated into the decision making. More on that shortly.
Crucially, however, active managers can potentially capitalise on prevailing and expected market conditions and provide diversification in varying degrees, as appropriate. The challenge, of course, is to find talented active managers who have and will continue to demonstrate skill, while remaining acutely aware of the capacity constraints that can compromise their strategy.
Active-passive in fixed income
Integrating ESG risk factors
Within the index tracking space, the growth in focus on ESG considerations has seen a proliferation of rulesbased screened and tilted ESG index funds. These respectively exclude certain index constituents and/or industries and tilt index weightings to or from certain companies and/or sectors, based on the ESG ratings of one of a multiplicity of ratings providers, each with their own scoring methodologies. While screening or exclusion continues to be the most common indexing approach, excluding too many companies or sectors both concentrates risk and may not necessarily have the intended positive impact on company behaviours and business models. Indeed, without engagement both are unlikely to change.10 Moreover, those broadly based ESG-oriented index funds with a large number of constituents make it less likely that every company will be engaged with. That said, those index ESG index strategies that employ a best-in-class approach, rather than one dictated by ESG scores which often results in entire sectors being excluded, are less likely to concentrate risk unless an unfettered market cap-weighting methodology is applied.
As noted above, an active approach to ESG integration requires a much more research-intensive process, within which engagement is integral. Indeed, given the importance of engagement to better quality and more sustainable long-term returns and the delivery of positive real-world outcomes, truly active managers exert their influence as active owners of invested capital. As such, they are potentially better positioned to have a greater impact on ESG issues than strategies that rely heavily or solely on screening. That said, the level of integration and engagement varies between asset classes – the limiting factor typically being the availability of data.11 Moreover, active managers can better navigate and reconcile the multitude of complex ESG scoring methodologies employed by different providers. In addition, with the externalities arising from unsustainable and ultimately unproductive corporate activities not being fully internalised into market prices, and financial markets misallocating capital to companies on the basis of incomplete information, integrating ESG into an intelligently applied active approach reinforces active managers’ raison d’etre – the potential to exploit the resulting pricing anomalies. At least for now.
Some active managers also engage in impact investing. This goes beyond traditional responsible and sustainable investing by targeting positive real-world environmental and/or social outcomes in addition to financial returns. Areas of focus include climate, energy transition, biodiversity and sustainable agriculture, as well as prominent social/levelling up themes such as financial inclusion, education and public health.
Why does this matter?
By way of conclusion, let’s finish on the note on which we started. Active and passive fund management are not mutually exclusive. Indeed, most investors will approach the active-passive decision on an asset class by asset class basis and construct portfolios that comprise both actively and passively managed asset classes. After all, the appropriate active-passive asset mix for any investor depends not only on their investment beliefs – principally around how markets function, how securities are priced and the value of diversification – but also on their investment goals, governance budget, risk appetite and how they frame risk.
Furthermore, approaching the active-passive decision through a narrow cost, rather than wider net value added, lens, will inevitably result in a sub-par outcome. Indeed, the dichotomy of outcomes resulting from a narrow cost versus wider net value added focus will become ever more significant as approaches to managing ESG risk factors develop. In fact, as this becomes an increasingly prominent component of investment outcomes, the likelihood is that active fund management will become further differentiated from passive.
The relative merits of active and passive fund management is already one of the longest running investment debates. With much more yet to further differentiate the two approaches to managing myriad asset classes – not least the management of ESG risk factors – the debate will no doubt run for a while yet.Â
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