Perspectives - ‘This time is different’ or ‘adapt or die’ – which is it?

Active investment management has lost huge amounts of market share over the past decades. The simple fact is the average active manager typically has not outperformed an index as a result of higher fees. At least in the case of equity sectors. This has been less true in the mixed asset sectors, where active management has been able to add value. The same can be said of income creation, where a passive approach is less able to manage the income stream from a portfolio.

To compound things, in the case of many equity strategies, a clear majority of managers have failed to beat their benchmark. Therefore, advisers and end clients have made the obvious choice to go with the lower cost, better performing option. The active management industry has compounded its competitive disadvantage, rather than adapt to the threat from passives.

As passives have grown, the dynamics of equity markets have changed considerably. Historically, active managers relied on, what you might term, CFA based investment techniques. Large institutional investors had banks of CFA trained analysts researching investments. They would attempt to forecast future outcomes for companies, build large and complex models and use sophisticated valuation techniques to come up with a price target. They were basing their investment decisions on a concept of fundamental value.

These approaches are still widespread in active management circles, and they may have been hugely successful in the past. However, the reality is that much of the market has been disconnected from active managers’ preferred valuation methods for a considerable period of time.

Something has changed in markets and it may be a self-reinforcing change. As active managers have lost share, hedge funds, traders and retail investors have gained share, alongside the now dominant passives. This means that the clear majority of investors making day to day decisions are indifferent to the whims of traditional active managers. Indeed, in the case of passives they prefer stocks that are larger as they constitute a bigger share of the index!

Hedge funds, traders and retail are typically much more focussed on shorter time periods. Hedge funds are judged on monthly performance, they cannot afford to sit and wait for fundamental fair value to be discovered. For them, momentum is all.

At the same time, as index funds gain share, they drive the outperformance of larger stocks over the average, simply because the active managers tend to own the smaller ones. This of course is a choice active managers make, not an obligation. As larger stocks have become relatively more ‘expensive’, on the techniques active managers tend to favour, they have become more underweight.

This change in the way shares are priced impacts on corporate behaviour also. An extreme example would be Tesla, which pays more attention to the management of its investor fan base than its business. While we may see this as absurd, it has clearly been a hugely successful strategy at generating shareholder value. Less extreme examples abound.

Active investors, in many cases, are assuming these conditions are temporary. The careers of most long-standing active managers are littered with powerful trends away from ‘fair value’, followed by mean reversion events such as the tech bust and the GFC. Repeatedly we have heard ‘this time is different’ just prior to one of these mean reversions. Thinking that we will soon revert to past norms seems rational.

We do not look at it this way. The market is the way it is. In our view, our job as active investors is to adapt to the market. In the same way as we do not predict future economic events, we do not to predict the way the market will behave. We believe we must play the ball in front of us. As long as index funds and traders are gaining market share, their predilections will likely determine the outcomes.

David Jane

Premier Miton Macro Thematic Multi Asset Team