(From Issue 4, 2016)
Forgive active managers for feeling discouraged—the headlines, and fund flows, aren’t going their way.
“More Pain for Active Management,” “Active vs. Passive: Who’s Winning?” [take a guess] and simply “Active Funds Need Help” are just a sample.
“Assets continued to exit active U.S. equity funds, with an estimated $24 billion in outflows in September,” Morningstar announced in a recent release, reflecting a trend of similar announcements for the seemingly umpteenth time.
“Passive U.S. equity funds attracted steady flows,” it added in a twist of the knife.
It’s not simply inside baseball, and reported in the consumer press as well.
“The presiding argument for investing in index funds and passive exchange-traded funds is simple: They tend to cost less and perform better than their active counterparts,” CNBC recently reported to its armchair-investing viewership.
The case for passive strategies is well-known and well-documented, with academic research from Nobel Laureates at elite universities ready to silence dissenters. Indeed, investing behemoth Vanguard, Kool-Aid sipping Dimensional Fund Advisors and a host of others have built extremely successful business models simply by following an index.
It’s easy to see why.
The SPIVA U.S. Mid-Year 2016 Score-card found 85 percent of large-cap managers, 88 percent of mid-cap managers, and 88 percent of small-cap managers underperformed their benchmarks.
“Over the five-year period, 92 percent of large-cap managers, 88 percent of mid-cap managers, and 97.58 percent of small-cap managers lagged their respective benchmarks,” it further explained.
It was pretty much the same story for a 10-year investment horizon. Not bad for a strategy that legendary Vanguard founder John Bogle claims was called un-American when first introduced in the 1970s (forget the 70s, a recent research report from Sanford Bernstein called passive investing “worse than Marxism,”).
So is that it? Game over for active managers? Time to pack it in and go home?
Of course not, except maybe for those on the extremes of the taste great/less filling-style argument that active vs. passive has become. Even the aforementioned Vanguard, the reigning champ (by far) of passive investing, offers active products, with one-third of the firm’s assets currently in active funds.
Put simply, active management can and does add alpha over time. It’s all in how it’s strategically used, and how the manager behaves.
Those are big caveats, according to Tom Howard, CEO of AthenaInvest.
Also known as Dr. C. Thomas Howard, formerly of the University of Denver, he’s got some academic heft of his own, and finds that part of the problem is that 401(k) plat-forms, in particular, “demand closet indexers.”
“They want name brands with high assets and attractive investments,” he bluntly, and emphatically, states. “It leads to what we call the Portfolio Drag Index, which consists of three components; asset bloat, index-tracking and over-diversification, all which combine to act as a drag on performance.”
He claims that if active managers simply bought their buy-side analyst’s 10 or 15 best ideas, kept assets capped at $1 billion and didn’t track to an index, they would all outperform.
Unfortunately, he adds, closet indexers account for 70 percent to 80 percent of the industry, with true active managers accounting for only 10 percent to 15 percent.
“We think if you are going to charge an active fee, you should truly be an active manager,” Howard laments. “The average mutual fund holds 130 investments. An active manager should have no more than 20, with 10 to 15 as ideal. In this way they can take full advantage of the reduction in volatility, and still gain superior performance.”
Howard doesn’t hold back about whom he feels is doing it wrong, namely the large asset managers in the 401(k) space, and fur-ther claims that those companies could still have the same amount of assets without the performance-destroying factors.
“It’s our view that the world would then end up without closet indexers and only have true indexers and true active manag-ers,” Howard adds, “but here’s how it im-pacts 401(k)s; they won’t allow it to happen, and we only have ourselves to blame.
“That aside (and admittedly it’s a lot), when making the case for active management none of it will probably matter. The reason is that more and more active proponents say there’s no such thing as a passive target date fund, something 401(k) advisors and plan sponsors should examine. And the claim seems to be backed by target date fund flows, propping up some active managers that might otherwise see even worse outflows.
“Investment results are driven by active decisions related to asset allocation, glide path design and risk management,” according to Ravi Venkataraman, global head of Consultant Relations and Defined Contribution at MFS Investment Management.
“Recent market volatility is a good reminder of the importance of proper asset allocation and strong risk management,” Venkataraman noted in the MFS Defined Contribution Investment Trends Study, released earlier in 2016. “The careful implementation of these principles could help mitigate the potential cost of surprises that can derail investor portfolios, especially for those nearing retirement or those just beginning withdrawals.
“Even more neutral players, like Morningstar target date fund analyst Jeff Holt, agreed.
“You can’t go completely passive in TDFs because managers still have to make active decisions about allocations, regardless,” Holt said. “This is especially true now that the DOL has increased scrutiny as they attract more and more assets. It’s more important for plan sponsors and retirement plan advisors to really know what’s in them.”
While equity and bond ratios are widely publicized, what the underlying assets con-sist of exactly is often far less known, and that could be a big problem. Morningstar recently looked into what, exactly, is in the allocations, and Holt emphasized that it is incredibly important for plan sponsors and 401(k) advisors to know as well.
“Glide paths usually stick to equity and bond allocations, but we decided to peel it back a level further,” Holt explained. “We looked into exactly what was in the equity and bond allocations. What was the ratio of domestic to international equities, what about corporates versus TIPS, that sort of thing?”
In his annual 2016 “Surveying the Tar-get-Date Fund Landscape,” Holt noted that target-date funds overall continued their multiyear growth trend with an all-time high of $69 billion in positive net flows.
“Assets in target-date mutual funds grew to more than $763 billion by the end of 2015, up from $706 billion at year-end 2014,” he wrote. “For firms with established target-date offerings, these funds often play a meaningful role in their business success …of the 10 largest target-date mutual fund companies, target-date funds account for at least an estimated 20 percent of the mutual fund assets for T. Rowe Price, Principal, and TIAA-CREF.”
As such, flows—both in and out—can have a sizable effect on business results.
“The figures are especially striking for firms that primarily offer actively managed investments, where target-date inflows have often become the primary source of new assets [emphasis ours].”
So when all is said and done, target date funds appear to be a saving grace for active managers, and for good reason—it’s an area where unquestionably a certain degree of routine, hands-on management and decision-making is required. Combined with the ongoing and evergreen rise in retirement demographics, target date funds in the 401(k) space might just play a major role in the future of the active management industry.
With more than 20 years serving financial markets, John Sullivan is the former editor-in-chief of Investment Advisor magazine and retirement editor of ThinkAdvisor.com. Sullivan is also the former editor of Boomer Market Advisor and Bank Advisor magazines, and has a background in the insurance and investment industries in addition to his journalism roots.
