Active vs passive what is the right option

Active vs Passive What is the right option?

September 2014

Active vs Passive – What is the right option?

Overview The ever-evolving investment market is throwing up new challenges at investors every day. The investors, hit hard by declining aggregate returns, have started weighing the option of passive funds against their favourite active funds. To keep investors by their side and remain competitive, asset managers will have to come out with innovative products, such as smart passive funds; explore new territories; and expand their product portfolio. After all, it is all about the “survival of the fittest”.

Actively-managed funds – the market darlings so far – are facing headwinds for a variety of reasons. As if the changing market dynamics were not a challenge enough, now they have to deal with a structural shift in investors’ preference towards passive funds. Typically, active fund management indicates higher returns over the market benchmark; but in this volatile market, a majority of actively-managed funds have underperformed their respective benchmarks in the past few years.

This trend is quite disturbing for the investors who are in the constant lookout for good returns. In their quest to achieve attractive returns, they are trying out other options like exchange-traded funds (ETFs).

According to Morningstar, in the last decade, scales have tilted more towards ETFs and away from actively-managed funds. As of January 2014, investments in passively-managed funds accounted for 27% of the U.S. open ended mutual funds and ETF assets as compared to only 12% as of November 1, 2003.

Although investors have shown enthusiasm for equity and fixed-income exposure for passive fund management, the trend is more pronounced in equity.

The strategy for passive fixed-income investment is significantly different from that for traditional passive equity investment (ETFs). Fixed-income ETFs with an investment objective of only replicating an index require sampling or optimal management strategy, because fixed-income benchmarks are not tradable portfolios. These Indices, constructed to provide a theoretical benchmark to the market, usually include a large number of illiquid securities, and hence are very difficult to replicate without incurring substantial costs.

Keeping all the challenges in mind, asset management firms are coming out with innovative products.

Smart passive fund is one such product. It is an approach used by many prominent asset management companies, which replicates the index using key risk factors such as duration, curve duration and credit spread duration between the index and the ETF portfolio, and focuses on liquidity, market access and minimization of transaction costs.

Hence, passive investing is more applicable to equities than to the fixed-income world, given the fundamental issues with a passive-style investment approach.

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Actively managed funds facing headwinds.

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Enthusiasm towards passive funds more pronounced in equities.

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Smart passive replicates index using key risk factors

Bull Market in Bonds Is Over Active U.S. bond funds have performed well over the past few years. This outperformance was primarily a result of favourable central bank policies. Interestingly, the outperformance matrix turned thin in 2013, as the news on central bank tapering its “quantitative easing” policy unfolded. Percentage of funds outperforming the Barclays U.S. aggregate bond index plunged to 26% in 2013 from 78% a year ago.

Bonds Vs Stocks

Percentage of funds outperforming/underperforming Barclays U.S. Aggregate Bond Index 100%

50.00%

80%

40.00%

60%

30.00%

40% 20%

20.00%

0%

10.00%

-20%

0.00%

-40% -60%

-10.00%

-80%

-20.00%

-100% -30.00%

-120% 1998

-40.00%

1999

2000

2001

2002

2003

2004

2005

Percentage outperforming Barclays U.S. Aggregate Bond Index

-50.00% 1994

1995

1996

1997

1998

1999

2000

2001

Barclays Agg.

2002

2003

2004

Difference

2005

2006 S&P 500

2007

2008

2009

2010

2011

2012

2013

2006

2007

2008

2009

2010

2011

2012

2013

Percentage underforming Barclays U.S. Aggregate Bond Index

Source: Vanguard calculations, using data from Barclays Live and Morningstar, Inc. Note: Calculations include all funds existing for at least 36 months from 1998 through 2012 whose stated benchmark was the Barclays U.S. Aggregate Bond Index. For 2013, data is from Robasciotti.

Concern over U.S. Federal Reserve tapering the “quantitative easing” program caused investment-grade bonds to nosedive, their worst year since 1994; many believed it to be an end of the three-decade bond bull-run. Annual return in 2013 for Investment-grade U.S. bonds (Barclays U.S. Aggregate Bond Index) was -2.02%; for Short-term U.S. Treasuries (Barclays 1-3 Year U.S. Government Index) 0.37% and Intermediate-term U.S. Treasuries (Barclays U.S. Government Intermediate Index) -1.25%. Although bonds with the highest sensitivity to interest-rate movements performed poorly in 2013, their shortterm counterparts fared well. Short-term bonds are pinned to the Fed’s interest-rate policy. Since the Fed is not expected to raise rates until 2015, short-term bonds escaped the turmoil.

While 2013 would be remembered as one of the most difficult years for the bond market, equity market found its feet again. Also, high-yield bonds delivered strong performance (High yield bonds (Credit Suisse High Yield Index): 7.53%), mainly because of stronger economic growth and rising stock prices.

Strong performance from the most risky asset class in the fixed-income category indicates that the market is no longer shying away from risky investments. As evident from the chart, S&P 500 outperformed the Barclays aggregate bond index in the last couple of years, reflecting increasing risk appetite and shifting the focus of the fixed-income market back on equity.

With investors prompted by a strong US economy to park their assets in equity-focused funds or passive and smart passive funds to generate more absolute return (avoiding management fee and other expense), fixed-income funds face an uphill task of attracting investors in an adverse market environment.

FI Note Edit

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Investment grade funds under pressure following shift in monetary policy

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High yield bonds delivered a strong return

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Strong US economy would present challenges for the investment grade bond funds

What the Future Looks Like?

Asset management industry is at a critical juncture today, and the only certainty it provides in this turbulent environment is that it will look very different from what it looks today. Asset managers are facing new challenges, particularly as a result of new regulations and investors’ changing perception.

PwC forecasts a CAGR of 6% for the next six years, which is much higher than 1.4% recorded in the last five years. More than 40% asset managers in developed countries believe the most important geographical area of focus for the long term will be the emerging markets, which will provide opportunities to asset managers to launch new funds and expand their footprint. Though concentration of assets will still be mainly in the US and Europe, the emerging markets are set to catch up with and outrun the developed markets in the growth race of assets under management in years leading up to 2020 and beyond.

120.0

Products

2004

2007

2012

2020 E

Global AuM

37.3

59.4

63.9

101.7

of which mutual funds

16.1

25.4

27

41.2

of which active investments

15.1

23.3

23.6

30.8

of which passive investments

1.0

2.0

3.4

10.5

18.7

28.8

30.4

47.5

17.6

26.5

26.6

35.3

of which mandates of which active investments of which passive investments

1.2

2.3

3.9

12.2

of which alternatives

2.5

5.3

6.4

13.0

Source: Pw C analysis

Global AuM projection for 2020

AuM $trn

Global AuM USD Trillion

1.4 %

100.0 80.0

20.0 0.0

101.7

16.8 %

13.0

59.4

60.0 40.0

CAGR

6.0%

37.3 2.5 18.7 16.1 2004 Mutual Funds

63.9 6.4

9.3 %

28.8

30.4

5.7 %

25.4

27.0

5.4 %

5.3

2007 Mandates

2012 Alternative Investments

47.5

41.2

2020

Source PwC analysis

As traditional asset managers and hedge fund managers increasingly compete for the same investment dollars by selling similar products to the same groups of investors, they face tough questions about their existing operational structures. There is a strong need to innovate and offer customized products with better margins, as asset valuations have declined while high cost bases remain fixed. With significant fixed cost bases and poor aggregate revenues, forays into in-demand absolute return products that yield higher margins would be high on managers’ agendas. Beta products such as exchange-traded funds & passive funds and alpha products such as derivatives & REITs would become part of their portfolio along with traditional fixed-income strategies.

Distribution is becoming as critical a factor as fund performance. While performance remains the key factor in choosing a fund, ease of tracking investments is becoming important too. As a result, distribution would be addressed with a renewed vigour. Some prominent fund houses are also evaluating the option of entering the distribution business. While this option will provide them with an additional revenue source, it would be contrary to their traditional business.

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Increasing competition for the share of a limited pie would change the way asset management industry works. The course of investors’ action would ultimately be decided by investors’ preference for the asset class and the investment style.

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Asset management industry set for a renewed growth path

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Asset managers to explore new territories

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Intense competition among asset managers

FI Note Edit

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