An Empirical Epoch? The Orwellian Struggle Beneath the Active-Passive Empire

An Empirical Epoch? The Orwellian Struggle Beneath the Active-Passive Empire

The Association of Professional Fund Investors recently responded to the latest UK regulator consultation on the efficacy, cost and selection of active funds. The nigh 10 page response by the APFI (on behalf of UK Professional Fund Investors) sent a clear message that while the purpose of transparency was correct; the FCA was in danger of approaching the subject in a myopic and biased manner. Why?

The active-passive debate is being played out in a statistical arms race between academics, active managers, consultants, passives, index providers and various faction media on both sides. Simply put active fund supporters are losing the war.

The APFI noted: "The total number of firms quoted appear to be 1840, so an alternate interpretation would be the opposite: 0.5% of the firms control more than half the assets. You [FCA] do mention these very challenges, asset concentration and the cost disadvantages that smaller firms are facing, but it is a striking feature of the report that the oligopolistic nature of the market is not fully addressed, how it relates to asset management business models, marketing and thus potentially skew the wider active-passive debate being considered."

By 2024 Moody's predict that passive funds will overtake active funds in the US, in terms of assets under management. This will surprise some but not all. Passive providers (like 'Jack' Bogle's Vanguard and IShares) carefully weaved a narrative in the early years that the outright assets under management of passives was diminutive in comparison to active. However the growth of passive AUM has been both exponential in terms of investor behaviour and linear in terms of the redemption out of active. For every Pound/Dollar redeemed from active; another Pound/Dollar is invested in passive. Add to this the slow demise of fixed income markets post bond bubble, changing AM business, explosion of ETF and index based providers, large investor reserves in cash and the conditions for a 'Passive Spring' were well seeded. In short a very large proportion of the asset management industry has already decided to back passive on commercial (if not investor) grounds irrespective of the statistical outcome.

That charge is led by some heavyweight academic studies, most centre on the US mutual fund market (the world's biggest) and easy target supertanker funds like the creaking hull that is Fidelity's Magellan fund (the world's first supertanker). Then you have the clandestine players like Standard & Poor's that weigh in with their pro-passive studies like 'SPIVA'. Between S&P and Russell, active US managers have literally been penned into style-cap buckets for the best part of 20 years. Deviation is bad; do not deviate, do not 'drift'. The CFA and US adviser associations like the CFP have literally brainwashed a generation into a post Sharpe/Fama/Kaplan doctrine that active managers must stick to a bias above all else. This has been fortified by SEC and other regulators. Now the industry says active funds do not deliver within those confines.

Let us not forget that the greatest asset concentration and thus supertanker today is the S&P500 index itself and all replicants therein. The SPIVA report therefore becomes self-fuelling: index product momentum drives up the index, SPIVA then reports that active managers cannot outperform that momentum, active managers either diverge to find better capitalisation/valuation, which gets slammed by compliance teams as tracking error and attribution reports point to copious off-benchmark risk being added; or staying in the index and becoming accused of being 'quasi-trackers' maligned by popular media and Active Share. Then more money goes into the index via index products and around we go again. It is self-fulfilling and almost inimitable (until the herd decides to sell). It is arguably efficient in terms of price but not in terms of valuation. I am not a fan of massive free float indices, as you may have already guessed.

What then empirical evidence exists that challenges the might of SPIVA? Little. I googled 'active versus passive fund study'. For many the Google search is the de facto source of all fact and opinion. Let's ignore how search hits are themselves manipulated and agree that few tend to look beyond the first few pages of a related search. My search returned; 15 pages of hits; within the first 3 pages (about 25 hits) there was only one pro active study Defaqto from 2015, which while thought provoking is lacking in statistical firepower. Other studies do exist but very few post 2011. The sheer weight of pro-passive statistical studies is thus overwhelming. Whilst few point towards any sort of smoking gun other than cost or EMH; logically, if being empirical, one has to be led by the weight of evidence. One caveat is the problem with republishing. This occurs when a study is published and then cited/republished by a number of other sources. According to Google some of the academic studies are cited again between 300-1000 times. That's a lot of positive reinforcement for essentially one piece of analysis and amplifies the empirical gap between pro and con studies. The other issue is the dearth of practitioner-based research or studies. Most fund buyers have formed the great silence in the active-passive debate.

Where the 'resistance' has begun is through a new generation of empirical platforms. For example Fundscape has launched a year-long experiment to compare the performance of both advised and non-advised active and passive investment solutions. The 'Great British Wealth Off' will run until 1 February 2018 and could continue for another year if there is sufficient demand. Five investments were selected for the competition: one robo‐adviser (Moneyfarm), one active fund of funds (Architas MA Active Progressive), two active multi‐asset funds (MI Hawksmoor Vanbrugh and Royal London Sustainable World), and one passive fund of funds (Vanguard LifeStrategy 80% equity). Professional Adviser reported that "£300 has been invested in each fund, with only funds with the same Morningstar SRRI rating of four out of seven selected. The Moneyfarm profile chosen was 'pioneering investor' with a medium risk level." It is a narrow study and therefore unlikely to persuade many but it does challenge the previous convention that aggregate studies explain how the world works. That is only true if the median is relevant.

SharingAlpha is now well known to the industry and is designed to allow fund raters demonstrate an ability to pick funds that outperform an investable ETF benchmark; plus their analytical accuracy in terms of assessing people, price and portfolio (the 'Hit Score'). In time SharingAlpha may become the world's leading MI engine with regards to active fund selection. It's strength is its global breadth, community, real world decisions and investable benchmarks.

We should remind ourselves that the key aspect here is the fiduciary obligation and the investor experience. Both passive and active asset managers are driven (outside of a mutual model) to generate profit. Where that firm becomes big and accountable to shareholders before investors then the same dysfunctions, that have blighted active management, will commute to passive. This is not clear in the stats because the passive industry is embarked one huge loss-leading offensive to grab investor assets. We should be careful when the new leaders eventually take power. Active management (or at least research) is essential to price discovery, which does not work in a free float mechanism like the S&P500. Any order driven system needs at least one buyer (or seller) to trade based on valuation of future cash flow. The move to high frequency trading and program exchanges do little to help. Transparency of cost and value are essential for all funds but we should not automatically confuse low cost and race to the bottom as 'people champion' and we should be more questioning of broad studies that do not make any reference to underlying causality. Nonetheless, the active industry is losing the war because it (and active fund selectors) fail to produce convincing and counter-point empirical evidence.

"We are not interested in the good of others; we are interested solely in power, pure power. What pure power means you will understand presently. We are different from the oligarchies of the past in that we know what we are doing. All the others, even those who resemble ourselves, were cowards and hypocrites." George Orwell, 1984.

As an empiricist one has to wonder: where are the heroes? Perhaps it's you, me and the hundreds of other SharingAlpha fund raters.