February 1, 2018
Active and passive
Should you go for active or passive investments? In general, the team at Barclays would say active, as we believe it provides more value in many ways for clients. We have the rationale and track records to support that view. But we also recognise that passive management can have a role to play when cost and simplicity are key considerations, too.
The debate about active and passive investments has become polarised over recent years when some active equity managers have struggled to add value and the flows into passive products have picked up. At Barclays, we believe that much of this debate misses the point. We don’t see it as active or passive but as active and passive. It all depends on what you are looking at and what is important to you.
So, why should you care about this in the first place? The main reasons tend to be the long-term returns after fees and the profile of these returns, especially during sell-offs. Other considerations could be the impact on, and long-term sustainability of, financial markets.
More comprehensive studies show that most active managers in most asset classes outperform their passive comparisons over time. The picture has been biased by the focus on US large cap, where active managers have struggled for some time, and that active managers are often compared to their indices, leaving out the important fact that passive funds replicating these indices have fees.
The studies also usually look at the average or median active manager. We think that we can do better than that. Over 80 per cent of Barclays’ single asset class multi-manager funds have outperformed their passive comparisons after fees over five years, and 60 per cent performed better than the median Morningstar manager over the period. Over 70 per cent of our panel of active managers have outperformed the average over the past three years. Past performance of investments is not a reliable indicator of their future performance.
Patterns in active returns
There are some clear patterns within the active returns. Active management seems to generate more return within fixed income than equities, more within European and Asian equities than in the US, and more within small and mid-cap equities than large cap.
Why is this? It often boils down to a few key factors, such as the nature of the indices, how rich the opportunity sets are and how many investors within the area are primarily focused on returns. The success of active bond managers, for example, is often linked to the difficulties to replicate and rebalance the indices, the broad range of different bonds available to invest in, and that many fixed income investors have alternative goals to outright returns, such as central banks and insurance companies.
Active managers should be able to provide a better return profile than passive managers, especially when markets sell off. Passive management easily becomes a fairly basic momentum strategy, with the winners growing in the index, leading to concentrations in more expensive stocks, which the manager continues to hold as the market goes down. Active managers have tools to dampen this impact.
· At Barclays, we believe in active management but recognise that passive management has a role to play when costs and simplicity are key considerations
· Most active managers in most asset classes outperform passive comparisons. We have a strong and experienced manager and fund selection team, with a successful track record of picking the better active managers, further improving the odds for active management
· Active management seems to go through cycles and there are reasons to believe that recent headwinds will abate and the environment will turn more supportive
Impact on market and society
According to Barclays’ MultiManager Compass Q1 2018 report, there are also other arguments in favour of active management more linked to the impact on financial markets and society. Active managers provide a public good by making sure there is information in stock prices, making the allocation of capital in society more efficient.
There are also examples where passive investments can have a negative effect through so-called ‘adverse selection’ and ‘moral hazard’. For example, passive allocation of bonds following the index will favour borrowers with the largest debt. This incentive could lead to over-borrowing and delayed restructuring or reforms.
However, passive investments have a role to play and can, at times, be the best choice. The most obvious attraction is the lower fees. This can be an important consideration for those who focus more on costs than value for money. Passive investment vehicles are also simple and provide easy access to markets, which can be important for asset allocators. Many investors, including us, have propositions focused on adding value within asset allocation, while accessing the underlying markets with passive vehicles over short time horizons.
Another passive advantage is that they provide healthy competition for active managers, pushing them to provide value for money.
Active management going forward
The MultiManager Compass Q1 2018 reports also shows that active management seems to be cyclical, with recent years looking like the bottom. The factors behind these cycles are complex, but seem to be linked to the opportunity set, which in turn tends to be affected by macro policies and the business cycle.
Looking at the opportunity set, the higher the correlation between the securities, the more difficult it becomes to pick the winners and the losers. The correlation between different stocks – how much they move together – has been very high in many equity indices since the global financial crisis in 2008, and it is only of late that this correlation has fallen back to more normal levels. Any factor that acts like a tide that is ‘lifting all the boats’ will increase the correlation. The very loose monetary policy of central banks and their quantitative easing programmes are such factors.
The level of the so-called ‘small cap premium’ – the extra compensation you receive for holding smaller, less liquid equities – and the performance of defensive bond-like equities – often called ‘bond proxies’ – also tend to be important. Typically, active managers allocate more to small and medium cap stocks and tend to avoid such bond proxies. This allocation has been a headwind over the past few years.
Looking forward, there are reasons to believe that the environment for active will improve. The year has so far produced substantially better active results than in 2016. And with stock correlations falling, interest rates gradually edging higher, quantitative easing being phased out, the small cap premium recovering, and the rally in bond proxies seemingly having peaked, there should be continued support for active management.
Even though we don’t see a recession or equity bear market around the corner, there will be a time when the market will sell off in a
meaningful way. Looking at previous patterns, there are reasons to believe that well-diversified actively-managed portfolios will be more robust in such a scenario.
Myths and misconceptions
· You cannot invest directly in an index. You must buy a fund and a fund has a fee. Passive funds will underperform their benchmarks after fees. Many indices cannot be entirely replicated, e.g. within the bond area, and passive funds can therefore have significantly lower returns than their indices.
· Most active managers in most asset classes outperform their passive comparisons. Many studies are biased by focusing on US large cap equities, where active managers have been struggling, and by comparing against indices instead of passive funds.
· So called ‘smart beta’ solutions are only a subset of active investors, in this case with a very small amount of active management, usually provided through a simplified quantitative system. The amount of active management is usually measured either by the ‘tracking error’, the active risk, or ‘active share’ – how large the positions are relative to the index.
· Active investing is not a zero-sum game. Many investors are not primarily focused on active returns and have other objectives or agendas. Passive investors are one example. Within the active areas, central banks, insurance companies, employee investment plans and non-professional investors are a few examples.