As investment managers who have espoused the value of actively managing a portfolio to try to beat average market returns, we have consistently brought investors' attention to those arguments in favor of such an approach. We are particularly attentive when we see others making the arguments for us. We have referenced the topic in many posts such as this one and this one.
The active vs. passive debate can be complex for the typical investor to adequately evaluate. Nonetheless, the bias towards passive investment as a superior strategy has grown dramatically in recent years, particularly since the 2008-9 financial crisis. Financial media pundits have wholeheartedly embraced the passive form of investment, and both individual and institutional investors have voted with their funds in pouring assets into passive strategies.
Interestingly, it appears that the almost decade-long march towards more passive strategies is changing. In a recent article in the Financial Times, "Hungry Funds Look To Switch To Active Equity", the case is made that many institutional investors are looking to reverse that trend in the coming years. While the article suggests that more than simple equities are on the radar of these institutions, the point is clear that a change in trend may be happening.
Frankly, we believe the rush to passive over the years has become a major danger for the market and economy, in general, because of the affect such strategies can have on adequate price discovery. Essentially, if everyone were passive, how can companies be appropriately valued? What does such lack of reliable valuations mean for the economy? How can capital be effectively allocated in an environment where investors can't clearly determine value, ie., where are the good companies who deserve capital allocations?
We are proud that in this desert of active managers, our equity strategies have outperformed their benchmarks over the long term. So, apparently, we have bucked the trend. Yet, it doesn't give us comfort that the impact of passive investing may be much more significant than the effect the phenomenon has on the active investment management business. In the December 7th, 2017 article in "Chief Investment Officer" magazine entitled "Back to the Future", the author Vishesh Kumar gives a general overview of markets and touches on a number of investment trends. However, we found the key point in the article was a reference Kumar made to a Neuberger Berman research piece that discussed the type of market we have been in since the financial crisis of 2008-9 (a largely passive-dominant market) and what has driven it:
“Fueled by extraordinary global central bank intervention, equity markets have soared since their 2009 trough, leading to conditions unsupportive of traditional capitalism and active management, including high levels of correlation and low levels of dispersion,” Joseph Amato, Peter D’Onofrio, and Alessandra Rago from Neuberger Berman wrote in an October research report. “Stock correlations within the S&P 500, for example, have spiked nearly 20% since May 2009, depriving active managers of the opportunity to distinguish winners from losers through fundamental research. Post-crisis market conditions also suggest that the past decade is not an ideal timeframe over which to gauge an investment’s potential for long-term success across market cycles. We think central bank policy normalization could inspire a normalization in market dynamics."
Setting aside the change in trend back towards active management, it should concern every investor who believes in free enterprise capitalism and bases their investment decisions on finding the best companies in which to invest that recent government policies have served to stultify "traditional capitalism." It underscores what we have been saying for years about the heavy hand of government and its effects on the economy and capital formation. Too much government starves the economy and markets from the capital it needs to expand and redirects it towards, most often, inefficient government projects (a "Bridge to Nowhere" anyone?). Is it any wonder the number of public companies has been almost cut in half?
We really don't concern ourselves with whether or not the "trends" are in favor of active management or passive management: we will continue to seek out great businesses in which to invest capital. However, if the trends favoring passive over active are symptomatic of damaging policies which impede the proper allocation of capital, then we all should be concerned, professional investor or not.
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