Low fees continue to draw investors to passive investments, but will this competitive edge disappear as ETFs become increasingly complex? One investment professional gives his take on the rise of passives.
Selector: Pablo Valdes
Company: Orienta Capital
The growth of passives is so relentless that even strong performance from active management is only likely to slow its march forwards rather than reverse it. Marco Pinto, the head of Moody’s asset management ratings division, pinpointed the issue when he said: ‘Cheap is good, but even cheaper is better, that is the mantra of markets at the moment.’
On top of that, if we factor in statistics that show over the past 10 years, 87.5% of US equity funds underperformed their benchmark and more than half of all international and EM equity funds also lagged, the decision between passive vs active is clearly in favour of the former.
As the use of passive investment vehicles increases and the average actively managed dollar (after fees) returns less than its passively managed counterpart, the passive element is moving to the core of investment portfolios. Nevertheless, we are still convinced that active investment will win out in the long term.
Passives here to stay
To some extent, passives will be facing an untameable tailwind as long as active management fees remain relatively high and the effect of easing monetary policies around the world continues to support market valuations.
Fund managers are likely to use a complementary mix of passive and active to construct more efficient portfolios.
Finally, creativity and financial engineering have always been a constant in financial markets. Passives have already started to evolve from vanilla formats to more complex structures in order to offer new alternatives and meet investor needs. However, whether they will be able continue developing in this way and maintain a competitive edge on fees into the bargain, remains to be seen.
While the US market is probably the most efficient in the world, it is a different story in EM or niche segments. In these areas the number of analysts covering businesses is fewer, there is little public information and liquidity is not very healthy so mispricing opportunities appear frequently for those skilled enough to spot them.
However, it is not yet clear that market efficiency is the definitive factor to decide whether a passive or active approach is the more appropriate investment. Meanwhile, the arithmetic and perhaps more objective approach (Sharpe 1991), concludes that fees are one of the main drivers of final net performance. Therefore, on average, passive becomes the best choice, especially in those markets where fees are many and high.
These comments originally appeared in the May edition of the Citywire Selector magazine.