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Has passive peaked?

A unique market backdrop is just one factor behind the rise in passive investing. But as monetary policies and market dynamics shift, could we be seeing the 'peak' of the passive bull run?

by Richard Edgar, David Buckle Head of Investment Solutions Design, Martin Dropkin, Nick King Head of ETFs, Sonja Laud Head of Equities and Sebastian Morton-Clark

04 June 2018, 12:45 GMT

The world of passive investing has enjoyed phenomenal growth in recent years - the result of a fundamental shift in investor behaviour or simply the consequence of a unique market backdrop? And now that market dynamics and monetary policy are beginning to shift, could we be witnessing what might be the 'peak' of the passive bull run? What could that mean for investors?

In this in depth discussion, Richard Edgar, Editor in Chief, talks to Fidelity experts Nick King, Head of ETFs; Sonja Laud, Head of Equity; Head of Research for Fixed Income, Marty Dropkin; and Head of Investment Solutions Design, David Buckle, about where they see the relationship between active and passive investing heading and how investors should be thinking of the two as we potentially edge towards a new era for markets.

Transcript

Richard Edgar: The world of passive investment has enjoyed a glorious decade. Assets have flooded in following impressive returns, all delivered at a fraction of the cost of actively managed funds. But it’s not as simple as that. And as the market has matured the debate has intensified over the relative pros and cons of tracking an index or handing money over to portfolio managers to try to outperform the broader market. And it matters more than ever right now: market dynamics and monetary policy are shifting. Are we witnessing what might be the peak of the passive bull run? If so, what will passive providers need to do to keep up? How should active managers seize the moment? And how should investors best incorporate both in their portfolios?

Well I have a flock of fidelity experts joining me in the studio today to answer those questions. Nick King head of ETFs. Nick, what do you reckon has been the most exciting development in this market?

Nick King: So I would say it's the sheer scale of flows into the passive products. Flows over the decade from 2007 to 2017 where almost 3 trillion dollars - so huge sums of money.

Richard Edgar: Not to be sniffed at and you're delighted with it too as head of ETFs.

Nick King: Yes, absolutely.

Richard Edgar: Sonja Laud, head of equity, is here as well. Sonja, there's been a huge focus of late on the costs of active management. Has it been tough as an active manager recently?

Sonja Laud: I think it's fair to say that yes, it has been tough. Although I would say that the debate has been rather one-sided because obviously active is not only about the cost angle but more in terms of what the product really is producing for the end investor. As such I would hope that the debate going forward is more granular and is really looking at what the net return is that each product can contribute to the asset allocation.

Richard Edgar: And a granular debate is what I expect we'll be having this discussion as well. Marty Dropkin - hello to you - head of research for fixed income. I want to know is the active and passive argument a daily debate on the fixed income floor as well?

Marty Dropkin: It's less so than it would be in an equity world and that's because in fixed income the active passive debate is more of a continuum. There's a range of topics that we can talk about. It’s about a 10 per cent share of passive on the fixed income side but it's also a trickier thing to manage, to actually calculate.

Richard Edgar: Ok. Finally, David Buckle is here as well - head of investment solutions design. Now, David, as somebody who uses both active and passive in tailoring investment products to clients’ needs, have you noticed a change in attitudes amongst clients?

David Buckle: Yes, the key one is the attitude is it isn't active versus passive, it's low cost versus high cost. That's the driver of the flows into passive.

Richard Edgar: So perhaps we'll hear a little bit more about that. Well welcome to you all.

Market dynamics and the growth in passive [skip to here]

Let's talk first of all about the context here. Nick, let me come to you. You’re the passive guy in the room, if I can put it like that. You described the incredible growth of passive in recent years. It's a very agreeable market backdrop though that has supported the passive products. Give us a flavour of how well it's done over recent times.

Nick King: Taking equity markets as an example, the MSCI World Index has returned nearly 12 per cent per annum from 2009 to now. When returns from beta are so high it's easy for alpha to be forgotten. And then in addition, the correlations between stocks over this huge bull run have also been very high making it fairly difficult for active managers to generate alpha.

Richard Edgar: So we’re doing very well, almost without trying.

Nick King: Indeed. And I think on top of that, regulatory change is clearly also providing a tailwind for passive investing, placing a greater scrutiny on costs and transparency. Those two things coupled really have been the perfect environment.

Richard Edgar: But the environment is changing, isn’t it? And it can’t last forever. Sonja, the tectonic plates in markets of shifting. You hinted at this. Can you set out the new landscape that’s emerging? Now we don’t want to sound like we’re talking our own book here - Fidelity is a largely active house - but are there sunnier times ahead for active managers?

Sonja Laud: I would think so. And I think it’s important to understand what actually has led to this tremendous performance profile for passive i.e. you know what has been the driver of beta over the past couple of years. And I think here in particular it’s worth mentioning the unprecedented central bank support that actually has led to return dispersions being extremely low for global equity markets to have such a great year performance. And as such, the big question mark: if we are really heading from quantitative easing towards quantitative tightening is that finally the backdrop that will lead to higher return dispersions, which obviously is a much better backdrop for stock seeking, for active stock selection, and we believe that actually indeed this is what is happening.

David Buckle: Actually could I just jump in there. I think as an extension of Sonja's point, the fact that it's cost which is driving this is also effected by the level of interest rates. If interest rates are at 5 per cent it's less of a worry if you're paying an extra half a per cent for your fees on your product. If interest rates are zero it's hugely more impactful. So it may well be that the interest rate environment also drives the adjustment of pressure on fees.

Has passive peaked? [skip to here]

Richard Edgar: Nick, the question posed by this podcast is: has passive peaked? Would you agree with that?

Nick King: I think there's still scope for passive to continue to grow, particularly in fixed income markets where the level of passive assets isn't as high as it is within equities. But I would also agree with my colleagues that given that we have had this tremendous bull run with valuations being fairly high right now, I think that this is the type environment in which active investing can clearly add some value. So the flows will possibly slow down somewhat I think.

Richard Edgar: And Marty, what about the bond market? Because we've got a lot of different things going on here. How's it going to play out in your world?

Marty Dropkin: There probably is scope for more passive to appear in the fixed income world, but we do view it as a continuum. If you break down fixed income by asset class, I think there are certain asset classes which are much more prone to passive type funds. There are certain asset classes, picking up on what Sonja was talking about - about dispersion on the equity side - the same phenomenon will exist on the credit side. We think as rates start to rise we'll start to see credit dispersion and in an asset class where downside protection is really what you're looking for, with asymmetric returns, that idea that we have to avoid the losers becomes that much more important. And that's where the active side really kicks in.

Richard Edgar: Because you just can’t do that if your if you’re buying an index?

Marty Dropkin: Exactly.

Richard Edgar: And indices in fixed income are quite a different beast to equities.

Marty Dropkin: Yes. It’s almost a four letter word in fixed income…

Richard Edgar: Yes, my maths - I’m just trying to spell out indices… almost a four letter word.

Marty Dropkin: Almost.

Richard Edgar: I thought you were meant to be good at maths?

Marty Dropkin: I wouldn’t tout that. But fixed income has become much more a benchmark agnostic kind of asset class right now. In particular, when you see the rise of total return and asset return mandates, central bank mandates that are pushing on those particular areas, benchmarks become irrelevant almost. And so the idea of trying to outperform a benchmark becomes a non-issue. And that’s why I talk about this continuum of active versus passive. I think David talks about lower fees - that's clearly an issue in fixed income. That's probably rates driven as well. It's also just market driven, but I think as we leverage our research base across the entire continuum of funds that we run that becomes more the question I think.

Richard Edgar: And actually how passive is passive in terms of: there's a bewildering number of indices, Nick, in equities. You're still having to make a choice there. There is no binary, “It's either active or passive.” Is there?

Nick King: Yes, I agree. And I wouldn't say that what we've really experienced is just a shift from active to passive products. It's actually an unbundling of exposures. So institutional clients rather than historically investing the majority of their assets passively are now looking to separate their allocations to beta, to style risk, factor risk, and also to more idiosyncratic alpha. So I think it's just an evolution of what historically was classified as alpha has now been separated into different types of risk.

For and against: the academic case for passive investing [skip to here]

Richard Edgar: David, standing back a little bit, what is the case - the academic case, if you like - for passive investing?

David Buckle: The standard one is based on two things. Firstly, that because the active managers are trading amongst themselves, the average performance of the active management community must be zero. And then the academics went on to study if that was empirically true, found some results related to the US, and then the pushback was, “Ah, yes, but that's the average manager. What about a good manager?” And the academics then pushed back and said, “Well, they can’t be persistent because you can’t have, in the long run, negative performing managers. So in the end everyone must be zero.” They did some more empirical studies, showed there wasn’t much persistence. The point that those miss…

Richard Edgar: So far we’re keeping a lot of academics in work it seems…

David Buckle: Indeed, and I’m sure we will in the future because the point that’s being missed here, which is that next area I'd like to see for study, is that there would still be a role for active managers if an investor felt they could time their investments into actively managed products.

Richard Edgar: Explain that then.

David Buckle: Yes. So let's suppose there isn't any persistence in active management but you know as an investor when the good period is going to be for a particular fund. Then you would say, “I’m going to now enter that fund with an intention of exiting that fund.”

Richard Edgar: So there’s an active decision that's going on the part of the individual investor: “I’m going to give this fund manager my money or another one.”

David Buckle: Correct.

Richard Edgar: But that is quite a skill. Multi asset teams do that. But are you expecting individual investors to be making that?

David Buckle: They already do. And the point is, Richard, in terms of, “Is there a role for active or a case for active?”, is it's not a matter of whether they are good at it or not, it's a matter of whether they perceive themselves to be good at that. And then they would naturally have demand for active funds.

Richard Edgar: And Sonja, I’m sure you hear this as well. But David's already touched on one of the criticisms of that research.

Sonja Laud: Yes. I think part of the support for passive obviously has been the failure of some active managers to perform, although I think the whole argument has been led rather one-sidedly by the US market. Because what we have seen, if you look in more detail, it's been particularly the US fund managers and large caps that have had a horrific time over the past couple of years. Yet this is one of the most popular areas for active engagement i.e. investors love to own their actively managed US funds. With these managers struggling so badly it has become more one sided: “Oh yes, active cannot perform.” Rather than: “It’s US active managers.”

Richard Edgar: And that's because the market itself has done so well. There's been extraordinary beta and not much dispersion.

Sonja Laud: Yes. The leadership has been extremely narrow. the US market has been the worst in terms of return dispersions, the lack of volatility, and a very narrow leadership. As an active manager, if you didn't own the 10 leading stocks you had no chance whatsoever to outperform.

Richard Edgar: But if you were to go to small caps, or better still in emerging markets say…?

Sonja Laud: Exactly, you’re hitting on the most important points: it's the cap - the large versus small cap - and it's the efficiency of the market. The more efficient the market and the larger your cap spectrum the more difficult it is to outperform. So you have had large categories around emerging markets, small cap, that actually have delivered positive alpha over that time period. Yet because it's the US market that is the most popular, you have seen this rather kind of broad based “Active cannot perform” statement.

Richard Edgar: And Marty, it's all the harder still when you're making credit selection.

Marty Dropkin: What’s interesting is the same phenomenon that Sonja just described exists in fixed income. And if you think about the aggregate fixed income market, you really just needed to own treasury bonds for the last 20 or 30 years and you would have been doing very well. You would have had incredibly good returns. As rates start to rise and the market starts to probably look at some lower duration asset classes like a high yield asset class for instance, that's where credit work comes in and that's where differentiation comes in and that's where your need to kind of drill in and understand individual companies really steps up

Richard Edgar: And Nick King?

Nick King: So I would say it's about the combination of active and passive. It's using passive instruments where you think the markets are very efficient and generating alpha is going to be difficult. And then using the active products where you think there are opportunities for alpha. And actually it's this combination of both passive and active products, which groups like David's are putting together and actually using those passive instruments in a very active way.

Market threats: the economic impact [skip to here]

Richard Edgar: What are the dangers of passive?

David Buckle: The hidden danger of passive investing is that everyone goes passive and the market will cease to operate. That's an and point we probably won't ever get to.

Richard Edgar: Explain that because people would still be holding shares or credit. But why does that mean it's not working?

David Buckle: Well, why would there be a share? If you think, the secondary market is there because people want to get in and out of the primary market. They're happy to give money to a company if they think at some point they could get that money back. The secondary market is to do that - is to transfer your ownership to somebody else. If everybody goes passive there would be no transacting other than someone has retired and wants to sell their share and therefore someone who's trying to save for retirement can then buy the shares off them. But that would be the only transactions. And the notion of daily trading - it just wouldn't be there anymore. And as a result there wouldn't need to be a secondary market in that environment and then that would have an impact on the primary market. If everyone went passive there is the risk that it would actually slow down the efficient allocation of capital into an economy, which has a feedback loop to investors because that would lower the long term returns for investing.

Sonja Laud: I guess we have to go right back to the original purpose of capital markets; why we're here and what we as intermediaries are expected to achieve when we are handed capital and obviously employed in the market. And it's about the efficiency of markets, it’s the price discovery mechanism, but it's the long term impact obviously, the societal impact as well, and what we aim to achieve in improving corporate governance and the companies we invest in. And this is where the whole overall ESG complex comes in because here, clearly, the idea around engagement with corporates plays a much bigger role than what we sometimes claim to do in normal circumstances.

Richard Edgar: We’ll come to ESG in a moment, but I just want to come back to this idea about the role of active management within the economy. And I guess the point here David is that it's like natural selection, in terms of the efficient allocation. That we want the companies that aren't performing well - whether it's on the credit side or in equities - to fall by the wayside for that continued improvement.

David Buckle: And the opposite, Richard. Play a hypothetical situation: back in the 80s, Microsoft says, “Hey, we've invented Windows,” and there's no analysts. How do they get the capital to develop Windows to make it into what it is today? If everyone's passive the money doesn't flow to them because they're not in the index. So it's more that side of it than getting rid of the ones which are no longer wanted.

Richard Edgar: It's just completely static. And actually I suppose the danger [is] also on the on the credit side. So if you think about market weighting, it's going to the companies that already exist and our very large, and on the other side, in credit, the companies that are already heavily indebted that are in an index that money is flowing to.

Marty Dropkin: That's absolutely right and I think it's also pointing to this idea that credit is an asymmetric asset class. You buy a bond at par, at 100, and the best you can expect is to get a coupon and get your money back at the end of it. So in a passive world that's great. But the reality is that some companies do default and some companies take on too much debt, just as you've indicated Richard. [With] some companies something changes with the company - they've decided to make an acquisition [for example] which puts them in a precarious position. And in a passive world you wouldn't really pay attention to those things, you would just continue to buy the bonds as they sit in the index. Whereas what it takes is some research to figure out which ones of these are going to default - and they do default.

Richard Edgar: So if passive is only about a tenth of the market in fixed income, it's much larger than that in equities?

Nick King: Yes, I'd say more like a third.

Richard Edgar: A third. Ok. Has the pendulum gone too far yet, David?

David Buckle: No I don’t think so. It's hard to put a number on it. The pendulum has gone too far when the market stops operating correctly and we’re clearly not there. In equities, the trend is in the direction that's already been laid out. I have to say in fixed income I'm not so convinced. One thing that hasn't been mentioned yet regarding indices in fixed income is the indices in fixed income are what we call “constant maturity”: the bonds inside them are continually refreshed to keep it at a 10 year maturity. What we're seeing, is there's demand from investors who say, “Well, I know what my cash flow requirements are and therefore I need to hold the bonds to maturity. But I have no intention on continually extending the maturity, I just need them for the next 10 years and that's that.” So the notion of an index in fixed income is really quite different from the notion of an index in equities.

The investor’s perspective - who really cares? [skip to here]

Richard Edgar: That's the backdrop I suppose for us now. What are clients thinking about when they're making the decisions about incorporating either of these approaches - or it’s not either: you talked, Marty, about a continuum. There's a whole spectrum of different levels between the two ideas. So Sonja, from your experience of talking to clients?

Sonja Laud: I think what we've experienced is a rather one-sided debate for quite some time, which was obviously backed by the very positive beta backdrop, which allowed a very strong focus really just on the cost angle because passive seemed to fulfil everything that was needed. And if we consider the usual requirements of a client between risk, return, and now cost added to it, then obviously it's a triangular relationship that was very well helped by the market backdrop on the return side. Risk was very nicely manageable as well with volatility coming down, hence a very strong focus [of] “Ok, now let's just drive down costs.” If we are right in our forward looking statement that this is about to change, and that the beta return profile will moderate quite considerably, then investors will have to go back to the drawing board to find out how they can achieve the risk, return, cost angle that they have in mind. And what we've been experiencing so far is that there’s a lot more on net returns i.e. if there’s an active product that actually can deliver the excess return required then the clients are happy to see how this fits in the triangular relationship of the other two components, to make sure that they can achieve all of them. So a bit of a move away from just the cost angle to “Ok, now let’s get realistic on the other two as well.”

Richard Edgar: David, this is your bread and butter. How does it play out as you design solutions?

David Buckle: Yes, I think the key point is that most of the investors I speak to are really agnostic on the notion of passive versus active. They simply state an objective they’re trying to reach and there’s a cost restriction to reach it. So they are perfectly happy having a combination of active [and] passive. But the other element, which might be worth bringing Nick in for, is there's often a desire to have a particular fund structure - a type. And hitherto ETFs have been connected with passive (if you have any ETF, you’re passive). We have a lot of investors who like to use ETFs for other reasons - not because they're passive. So that's led them to have a passive investment, but that wasn't really the driver.

Richard Edgar: Was it the liquidity instead?

David Buckle: Yes and the fact it's on an exchange.

Richard Edgar: Nick?

Nick King: Yes, so many clients do like the convenience of the ETF wrapper. That's why we've chosen to offer our passive and smart beta products in a combination of mutual fund and ETF wrappers. But as David says, so far the vast majority of exchange traded products are index tracking products simply because there needs to be this requirement for transparency in order for the capital markets partners to provide liquidity on exchange for these products. However, there is a marketplace developing for active products and that's a space that we're going to watch closely.

Richard Edgar: Marty?

Marty Dropkin: There's an interesting follow up on the liquidity angle particularly within fixed income which historically has been a less liquid market. And when you think about ETFs and the bonds that go in ETFs - and there's a whole industry now to try and track which bonds are sitting in ETFs and which ones aren't sitting in ETFs and the market is trying to figure that out. That brings back the whole continuum of active and passive to the forefront as well. Which is: is it active? Is it passive? Is it actually passive if it's sitting in an ETF and everybody's already trying to game the system to figure out which bonds to buy.

Richard Edgar: And the answer is?

Marty Dropkin: The answer is: it depends.

Richard Edgar: Excellent.

ESG: Can passive be ethical? [skip to here]

Well Sonja, you brought up ESG (environment, social, governance) questions - stewardship. First of all, before we talk about passive, this is a very much more important aspect of investing nowadays than it was in time gone by. Your argument, I assume, would be that only through active can people engage with the companies to try and bring about change?

Sonja Laud: Overall, we are now witnessing much bigger demands towards us as the asset management industry to consider more societal issues in our selection process so that the pure corporate governance, improvement, and engagement goes beyond and is more specific towards those issues. Passive is well equipped to look at the best in class model and put it in a wrapper. Yet if we say we want to see improvement and engage with companies that probably today do not have the best ESG rating, this is where obviously we as active managers have a much bigger role to play. Because we can engage with corporates to say, “Ok, how do we get you from an ‘E’ rating to an ‘A’ rating?” And that obviously is a journey that from an investment and return angle could be potentially very interesting. And it's something we believe obviously only active can deliver at this point.

Richard Edgar: Nick, would you agree? Because if you're chucking money in an index that's it, that's the end of the engagement isn't it?

Nick King: I would say as the market for ESG products develops I think there’ll be a place for both active and passive products. At the passive end, there's a number of ESG data providers out there which can be used in a systematic strategy to get exposure to stocks which have good ESG credentials at low cost in a very transparent way. However, the passive products will always need to hold those companies. So whilst it can select those which have strong ESG characteristics it can’t exclude stocks because it doesn't like a particular element of its governance model.

Richard Edgar: That's a sort of backward looking approach - talking about companies that already have good ESG credentials or not. What about actually bringing about change? How does that happen?

David Buckle: I think ultimately here there is an argument you could make for passive management - and the active community would have to try and defend against it. And there's an argument for being active, which the passive has to defend. And this is the strongest argument for the active community. And the passive are defending it by saying that they're becoming more active. But the reality, as Nick's mentioned, is a passive manager cannot sell a security which is a big part of the index regardless of the efforts they might make to make it better on an ESG score.

Richard Edgar: Sonja, how do you see this developing?

Sonja Laud: I think there will be greater differentiation around the level of engagement, because as we know, [with] passive there are some claims that there would be greater engagement around voting at AGMs and things like that. Yet to me engagement really is sitting down with management to discuss what are the weak links in the ESG reports, what are the areas that we are concerned about and what is management doing to address these.

Nick King: And I think that's very consistent with how we would distinguish between active and passive now. So you've got low cost, systematic exposure to equities. You can take that further and have ESG equities that way. And then as we also invest vast amounts of time in fundamental research for our active products you can further that with additional ESG research. So I think there's space for a broad range of products across the spectrum.

Richard Edgar: So from an investors point of view, as well as society's needs then, having to balance the two different approaches and what they're able to deliver.

Active and passive: future symbiosis [skip to here]

We're almost out of time so I'm going to ask each of you know to think what is it that you'd like to leave in our listeners minds when they're thinking about active and passive, and this question, has passive peaked? Let me come to Nick first.

Nick King: I think the way you phrase your question is exactly correct: it's passive and active not passive versus active. And I think that there really is a place in portfolios for both. It's about identifying the places where you just want very efficient, low cost exposure to a particular asset class or segment of the market. And then using allocations to active and factor products where you want to have the potential to add some value.

Richard Edgar: Marty?

Marty Dropkin: We're just exiting a period where rates have come down and we’re starting to see rate rises. With that, I very strongly believe we will start to see more credit spread dispersion which means that this era of beta-like returns - whether it's equities or fixed income - is likely to slowly come to an end. And as that comes to an end and as differentiating between companies becomes that much more important that's where active will kick in.

Richard Edgar: Sonja?

Sonja Laud: I think investors really should be prepared for changes in the market backdrop and changes that will unfold over a long period of time, because we have to be realistic that 10 years of unprecedented monetary support will take a lot of time to normalise. I think investors will do very well to reassess their current allocation, not only in the context of a more moderate return profile going forward, but in the context of: maybe there's too much passive. Where are the areas we feel are the greatest opportunities not only for active but in general to invest in right now.

Richard Edgar: So time for a review. David, finally, what would a portfolio of the future look like?

David Buckle: It'll be a combination of active and passive. I don’t see it as a binary thing. But the one message I would leave - this is a message to any investor - is you have a duty of care for the market. And there’s a prisoner's dilemma: passive is cheaper wo what everyone wants is for them to be passive but everybody else to be active to keep the market going. So as much as you might choose some passive, do be cognizant of the fact that the more you move into passive the more you’re creating the risk that you’ll disrupt the market that you need to make your investment.

Richard Edgar: There’s a symbiosis between the two, perhaps?

David Buckle: Indeed.

Richard Edgar: I'm afraid we are out of time now. Nick King, head of ETFs, Sonja Laud, head of equity, Marty Dropkin, head of research for fixed income, and David Buckle, head of investment solutions design at Fidelity. Thank you all. And thank you for listening to what I hope you agree has been a fascinating debate. Goodbye.

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