By Michael Gordon*
The rise of passive management is one of the greatest and probably most significant trends in asset management in recent years. The case for passive investing is well known and is hard to refute. However, there are hidden costs. Not just for investors, but for whole economies too.
The lure of lower headline costs, the hurdle of market efficiency and the concept of better risk budgeting all make perfect sense to the asset owner and are hard to challenge.
Together they are contributing to one of the most powerful industry forces we have witnessed. The ‘Financial Times’ recently reported that passive funds grew four-and-a-half times faster than active funds in calendar 2016 and Moody’s has predicted that by 2024 in the US the passive investment industry will exceed its active counterpart. To the traditional asset management industry it’s disruptive and it’s real.
From an individual asset owner’s point of view and over a medium-term time frame there is little wrong with this. The arguments for the passive management of listed assets do make sense. But when the consideration is broadened beyond the individual and to the economy and society as a whole, some questions begin to emerge. In the long run, these questions may not be insignificant.
Passive investing is almost totally restricted to listed assets and most debate around its merit, or otherwise, generally focuses on the “performance” of equity investing. As part of this thinking it’s acknowledged that the share price of a company reflects its financial health and its future prospects. The debate exists around an active manager’s repeated ability to forecast or predict those prospects.
In considering a company what is not often debated is the likelihood of that company being able to continue to contribute to the health of the economy, through the provision of goods, services and of course, employment. To do so, a company needs capital. Thus, the effective and efficient provision or withdrawal of capital to a company is a key decision in the effective functioning of an economy and a capitalist society.
Economics has long been simply defined to high school students as the allocation of scarce resources. Investor and superannuation capital is one such resource, a major one at that. If capital is not allocated effectively then economies cannot not work effectively.
Economics is a science and economists love assumptions. So, let us indulge and assume a world where passive investing in equities is all that occurs and there is zero active management. In that purely passive scenario, BP is worth the same after the Deepwater Horizon oil spill of 2010 as beforehand and BHP, likewise, following its troubles in Brazil, not to mention any number of global banks before and after the GFC. How and why is that so?
It’s because, in this purely passive world, no active capital allocation decision is made. To contemplate a world where the capital allocated today and tomorrow, is identical to that of the previous day, week or month is a sobering thought. The ‘animal spirits’ upon which capital thrives are muzzled if not completely strangled. Those who succeed are not rewarded and those who waste capital are not punished. And what reward is there for innovation?
It is interesting, also, to ponder how new companies might come to the market where there are no active managers to price them. Would ASIC or the ASX, perhaps, invoke a formulaic methodology that would determine what size and valuation would be appropriate? Or could we just leave the decision to the bankers who promote them?
Similarly, the question is relevant with other corporate actions such as takeovers and capital raisings. Under this malefic scenario of a world of purely passive management, who would take the role that the active managers play in keeping bankers honest with respect to the pricing and sizing of deals?
Also, what would become of smart beta in this world? Quite simply, it would die as there really would be no differential in what would become a “planned equity market”. Intra-market factors that can be explained scientifically and are driven by the observation of the fundamental and active stockpicking decisions of the past would cease to shift the market. They would exist at a point in time, when the last active decision is made, but remain static thereafter. What would remain is what passive managers provide: beta, pure and simple.
Asset allocators would remain active, of course. But how might they view this new equity market? I think its fair to assume that without active stockpickers holding boards and company management to account, capital within the equity market would become increasingly poorly allocated. In that event the market would produce lower returns over time. Allocations to an equity market without the presence of the judgement of active managers would surely fall.
Of course there is no suggestion that the world will move to a situation where capital is 100 per cent passively allocated. However, as the proportion of assets managed passively rises, the remainder which is allocated actively will, by definition, be done so less and less by professional investors.
From a societal point of view, a purely passive allocation of capital to corporates is surely undesirable. From an individual or super fund’s point of view it could well be too.
Solving the conundrum between self and society is not a new problem and it presents itself daily, in all forms of life. Contemplating the dilemma of a purely passive equity market, the conundrum is real, particularly with so much of Australian’s asset ownership in superannuation, which is governed by the SIS Act. It is worthwhile remembering that SIS and its “sole purpose” test requires that the fund is maintained for the sole purpose of providing benefits to its members upon their retirement. Over the years, some in the industry have seen their purpose as wider than that but the legislation is clear. A superannuation trustee cannot really concern his or herself with the wider functioning of the economy and the allocation of capital across it, much as they may wish to.
Active fund management is not quite “god’s work”, as one US investment banking leader chose to say when defending his company’s place in the world in the aftermath of the GFC. But it does play a vital role in the effective functioning of a capitalist system and our whole society.
Similarly, if the sole purpose test serves to drive outcomes that could damage society, in time it might need to be debated. In fact, let’s debate it now.
While there are those who may argue against capitalism or see its faults and flaws, there can be little doubt that it’s the way our economy operates today and effective allocation of capital is key to its ongoing success.
The active equity management industry has a purpose to serve the economy and society well beyond its alpha and tracking error metrics. It behooves those within it to make the case more effectively than we have done to date.
*Michael Gordon is a non-executive director of several asset owner entities in Australia and Asia. He is a former head of investments at Perpetual, at Fidelity in APAC, at BNP Investment Partners globally in London, and the co-chief executive and CIO of Schroder Australia.