Passive is (Still) Massive as Stock Selection “Sinks into a Swoon”

In January 2015, in an interview in the London-based Financial News, I argued that the 20%  allocation to passive investment by institutional investors, including family offices, would double over the following five years.

Almost on schedule, we are now approaching the 40% allocation to passive mark, (including “smart beta” funds and ETFs), for most institutional asset owners and large family offices in North America, Western Europe and the Asia Pacific.

The record wealth of the venture capital and private equity industry comes, to a large extent, from the hundreds of billions in net new money flowing every year from clients who keep on reducing their exposure to plain-vanilla government bonds, listed equities and actively-managed funds

I believe that this threshold, reached eleven years after the start of the “Great Financial Crisis”, says a lot about the state of the financial industry as a whole. 

Here, I will try to explain why, while sharing with the readers of Family Capital some of the preliminary findings of an on-going Singapore Economic Forum research project on “The Asset Owner of the Future: Risks, Returns and Realism in the Age of Geo-economics” . It will be finalised and presented in the first quarter of 2020.

Several factors have pushed investors towards passive strategies. First, there is cost-cutting and “rationalisation”, a sweeping movement made all the more acute by the persistent policy of ultra-low interest rates which makes the fees charged by active asset managers look expensive in relative terms. 

Many of the central bankers and financial regulators were happy to look the other way for years while faux-active managers and pricey actuaries turned consultants charged their toll. Now they are, all of a sudden, virtue-signalling, putting unprecedented pressure on institutions to “do the right thing.”

The Central Bank of Ireland is currently probing a whopping 182 funds for potential “closet tracking” and “poor governance.” In the name of managerial efficiency, policymakers and regulators are simply joining the bandwagon. Their prescriptions will only accelerate the existing trend towards an increased allocation to passive, because the willingness to take risks is being squeezed out of the system. 

With a bit of nudging from their regulatory overseers, institutional investors are further switching to passive because awareness has grown that is really hard for most active managers to beat the market. 

Data published by S&P in the US makes uncomfortable reading. It shows “active managers continue to show dismal performance against their passive benchmarks. For the ninth consecutive year, the majority (64.49 percent) of large-cap funds lagged the S&P 500.”

I am convinced the increasing incapacity of many long-only active-stock-pickers to generate performance above and beyond their benchmarks is due in large part to the wear and tear of their tools, including the banalisation of modern stock selection techniques. 

Once the preserve of a handful of Old Etonian and Ivy League experts such as Ben Graham, the Anglo-American mentor of Warren Buffett, sophisticated stock-picking notions such as “intrinsic value” and “modern financial analysis” are now taught to hundreds of thousands of undergraduate, MBA and CFA students every year, including tens of thousands in China, India, Mexico and Indonesia.

As the global market pond becomes crowded with growing cohorts of fishermen using the same fishing rods at the same time, their clients are not likely to witness a “miraculous catch of fish” any time soon, as their manager’s bright ideas are steadily arbitraged away. And, as markets become more efficient and active managers fall in number, any decision to stray away from the index will become increasingly difficult to justify, and, often, pointless.    

The fact that the investment tools used by active managers are losing their sharpness has been amplified by the robotisation of finance, with “quantitative portfolios” and “smart beta funds” evolving into sub-categories of passive management. For a while, some super-smart hedge funds used their computers to outperform. Now, many of their skills have become commonplace.

From a socio-political standpoint, this dramatic shift means that active stock-pickers, until recently “the aristocrats of finance”, are steadily falling from their pedestals on Wall Street and in the City of London. 

They’re being replaced by a richer, politically connected, elite, namely the venture-capital and private equity investors of San Francisco, Boston, Hong Kong, Toronto and Midtown Manhattan.

It may be no coincidence that many of the large donors bankrolling the Clinton, Trump  and Macron presidential campaigns in 2016 and 2017 came from that small social set – their unprecedented nouveau wealth has gone on to fuel the rise of a new breed of cash-rich, financially-savvy, family offices, many of whom have been backing private assets, led by real estate and family businesses, for generations.

The record wealth of the venture capital and private equity industry comes, to a large extent, from the hundreds of billions in net new money flowing every year from clients who keep on reducing their exposure to plain-vanilla government bonds, listed equities and actively-managed funds.

I do not believe that this strong, secular trend will stop in the coming years. We should brace ourselves for a “new investment normal”. Ratings agency Moody’s has predicted that more than 50% of the US market will be indexed by 2021.

By the year 2022, we may well see many pension funds, family offices and endowments with a 55%+ average exposure to passive investment vehicles (including bond ETFs and quantitative funds), 30% private assets (including private debt, real estate and infrastructure funds) and less than 15% actively managed equity mandates.   

The tentative findings and personal interpretations and conclusions expressed in the article are those of the author, and thus do not represent the views of the Singapore Economic Forum, the World Pensions Council or the World Bank or any of their members.  

Nicolas J. Firzli, Chairman, Singapore Economic Forum (SEF), Director-General, World Pensions Council (WPC) and Advisory Board Member, World Bank Global Infrastructure Facility (GIF)