For active managers, the path ahead is narrower and more demanding, but those who can align with evolving investor needs and deliver tangible value will find that their relevance is not obsolete.
By Clare Flynn Levy
Clare Flynn Levy is CEO & Founder of Essentia Analytics. Prior to setting up Essentia, she spent ten years as a fund manager, in both active equity (running over $1B of pension funds for Deutsche Asset Management), and hedge (as founder and CIO of Avocet Capital Management, a specialist tech fund manager).
As a former active equity fund manager, and a current expert in analysis of active manager skill, this image, which appeared in a recent Financial Times article, elicits a feeling of nausea. I’m no technical analyst, but the trend is not (as they say) the active equity manager’s friend:
To hear hedge fund manager David Einhorn tell it, the active long-only equity business is already dead. So is it finally time to give up the ghost?
Investment management exists to be active
Here’s the thing: the investment management industry is, at its essence, selling decision-making as a service. Which decisions are being made, by whom, and wrapped in what package, is constantly changing as the industry comes out with new and differentiated products to meet the evolving needs of the world’s savers. But wherever decisions are being made that result in divergence from the market index, that investment management is active.
As the ETF market grows, we’re watching the line between “active” and “passive” funds disappear. Is an ETF that exists to track a bespoke index an active fund or a passive one? What about direct indexing – is that active or passive?
From where I’m sitting, they are all active – just to varying degrees. Active is about decision-making, and decision-making lives on, as it always has, as the ultimate value-add of the investment management industry.
Fund selection is active investment management
Whether you’re a financial adviser or an individual investor, it’s never been easier to be your own fund manager. If you’ve got the confidence, the tech tools are there. But if you’ve ever tried to do the job yourself, you’ll know that even if you’re just selecting index funds once a year, you’re making active decisions – and those decisions aren’t as simple to make as they sound. The answer to the question “is this portfolio going to perform the way we’re predicting it will?” is never as clear as one might hope.
Fund research teams exist to do the homework that the rest of us don’t have the time, resources and/or interest to do well ourselves. It is a big part of the value add – or at least the marketing pitches – of most financial advisers and OCIOs. And the practical fact is, even in the absence of kick-backs from fund manufacturers (outlawed in the US by the Department of Labor Fiduciary Rule and in the UK by the Retail Distribution Review), there’s little incentive for the majority of financial advisors to focus entirely on index funds, lest their own fees become that much harder to justify.
Index funds are getting riskier
While a diversified portfolio may have a smaller allocation to public equities than it did ten years ago, thanks largely to the growth in allocations to alternative assets, it still remains the largest piece of the pie for most investors and it will continue to do so as long as the data on equity returns over time holds up. If you’re a US equity investor, the last two years of 20%+ equity index returns certainly help that case.
But index funds are getting riskier: between the exponential growth of the tech companies that lead the major US indexes and the steady linear growth in capital flowing into index funds, things are getting scary. Given the outsized influence of a small number of tech names, market cap-weighted indices are becoming dangerously concentrated and no longer fit for purpose – whether that purpose is to serve as a benchmark or to provide diversified returns.
The impact this is having on the structure of the markets is concerning. Einhorn isn’t the only one out there calling the US market “fundamentally broken.” While I tend less toward the dramatic, I agree with the sentiment. To me, the scariest part is that all of the equity risk and performance models that are in use by all of the asset allocators out there are based on data from years past, when indexes were nowhere near as concentrated. That makes those assumptions significantly less reliable.
Index providers are increasingly offering equally-weighted versions of their indexes, which is helpful. But whether the index is being used as a benchmark or as an investment, there is a lot of backtesting and admin to be done before we’ll see these new versions take center stage.
In the meantime, at Essentia Analytics, we’re seeing renewed interest in active equity managers from the world’s largest institutional investors, who are re-thinking risk in the context of index fund concentration. Their shortlists are shorter than they used to be, and their due diligence requirements are significantly greater, but the demand is there. And for an active equity manager, the value of being on those shortlists can mean the difference between life and death.
Adapt or die
In 2016, Eric Rovick, a former Research Director at Fidelity International, wrote a paper entitled “Can Traditional Active Management Be Saved?” The punchline was that yes, salvation was possible, but only for active managers who made concerted efforts to raise their performance game by mitigating their biases and optimizing their investment processes. The crucial question, Eric pointed out, was whether asset management CEOs, CIOs and portfolio managers would be willing to make the effort to adapt. Nine years later, the graph above would imply that the answer to both questions was, unfortunately, no.
Now that active equity fund managers are having their near-death experience, my sincere hope is that change is finally afoot. The signs are there. New leadership has a critical mandate to improve both performance and cost-income ratios. Resistance to moving with the times is no longer tolerated. Innovation around product and distribution is valued more highly than ever.
I say near-death because it’s easy to forget that even in the US, where passive funds have the most traction, 50% of total assets are still in active funds. If nothing happens to slow the rate at which money is moving from active to passive, it will be another ten years before active funds sink to 25% of total US assets. There’s still time.
While the rise of index ETFs has reshaped the public equity landscape, active decision-making remains integral to the investment management industry. As index concentration introduces new risks, and institutional investors increasingly scrutinize their allocations, demand for skillful active managers remains.
For active managers, the path ahead is narrower and more demanding, but those who can align with evolving investor needs and deliver tangible value will find that their relevance, though tested, is not obsolete. The industry’s challenge is not survival—it’s transformation.
