These days, few if any investment writers wholeheartedly support active management. They either recommend passive investing fully or they advocate blending the two approaches, typically by starting with a core of passive investments and then adding active funds as desired.
Active management choices are often now in the form of strategic beta, which matches some of the benefits of active fund management with the lower costs associated with passive investments.
The strategic-beta approach, which oftens means that ideas are human but that the execution is done by a computer, has the advantage of costing less than traditional active management.
Underlying expenses are not all that different between the two forms of management, because both traditional investment approaches and strategic beta require a qualified fund manager and both often use similar amounts of in-house research. But strategic beta is generally offered through exchange-traded funds, and the convention is that ETFs underprice active funds.
The current thinking is that active management has done itself a disservice in two ways, on high fees, and by encouraging short-term investor behaviour by offering new funds based on previously high-performing sectors.
There's no question that active funds charge aggressively. Historically, the industry has combined lofty employee salaries with high profit margins. Unlike firms in most other industries, fund companies don't go bankrupt - the rare exceptions being firms that suffered major regulatory problems. Once they hit a certain size, they either make huge profits or - if things go badly - large profits. All major fund companies could slash their fees without endangering their survival.
The Case for the Defence
One argument is that funds are far from the costliest form of active management. The typical actively managed US fund carries annual expenses of about 1% a year; this is somewhat less for the big funds that buy blue chips, somewhat more for smaller, specialised funds. Meanwhile, the conventional fees for hedge funds have been 2% of assets, along with an additional 20% of the year's profits. Funds-of-hedge-funds have cost even more, because of their additional layer of fees.
By hedge fund standards, then, funds have been discounters. Indeed, although this no longer remains a problem, in the 1990s several of the most-successful fund managers were poached by hedge funds, offering pay packages the fund companies could not match. Activefunds are aggressively priced when compared with ETFs, but conservatively so when compared with hedge funds.
The other counterargument is that even drastic fee cuts would not have changed the story. In the last five years, the average large-cap fund gained 13.41%, while comparable exchange traded funds have risen nearly 15%. Active managers could have given their funds away and still trailed, on average.
Selling the Next Big Thing
It is true that fund companies pander to investors. Rather than promote their funds consistently over time, so that each fund receives roughly the same share of the marketing budget from year to year, companies typically advertise what has performed recently well and keep quiet about what hasn't. In addition, most new launches follow the financial markets rather than attempt to lead them. By and large, fund companies sell what they believe the people want, rather than what they need.
However, this habit is not limited to active managers. Selling past performance means, for the most part, selling asset classes. Small-company stocks have been performing well: let's promote our emerging-markets fund. Gold has rallied: did you know that we offer a precious-metals fund? Such news doesn't affect the handful of companies that run the giant passive funds, which invest very broadly, but it does drive the marketing of many secondary providers. Indexers pander, too.
And active managers have done themselves no favours by attacking passive managers. They would have more credibility had they just not said anything at all about the subject. Through the years, active management's jibes have ranged from silly - "indexing is anti-American" - to underhanded - "index funds are destabilising the stock market".
The better approach would have been to take the threat of passive management seriously by investigating the numbers. Do some asset classes seem to benefit more than others from passive management? If so, why? Can we predict when market conditions will tend to favour passive management, and when active managers might fare better? Active managers have been conspicuously absent from such discussions. With a handful of exceptions, they have been content to disparage and have left the studies to index providers and third-party researchers.
Active funds have indeed charged too much and been marketed too haphazardly, although in their defence they are far from the worst offenders among investment managers. Perhaps their greatest error was dismissing the competition.
If active managers couldn’t spot the explosion in passive investing, should they be trusted to foretell other aspects of the financial markets?
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. While Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
