Paul Stewart: Too soon for obituary of active management

*This article is brought to you by Grindrod Asset Management, a leading South African provider of income-based portfolios suitable for retirement.

By Paul Stewart*

A huge groundswell of change is underway in many facets of life. The way mankind views politics, religion, education, health and finance are all going to change fundamentally over the next decade and beyond. Humanity is probably not sufficiently prepared for this onslaught which heralds much transformation and uncertainty. My sense is that no one emerges from this realignment process without a few bumps and bruises.

Paul Stewart Grindrod AM
Paul Stewart, Head of Fund Management at Grindrod Asset Management.

One of the key drivers moulding this new societal order is the rise of the individual. Technology now allows individuals to do what previously only powerful organisations or vested-interest groups could achieve. Technology and interconnectedness have handed individuals a voice, a vote and a veto. Cyber tools allow the formation of loosely connected cliques that are remote in geography, but powerful in number and volume. New technologies are becoming the bridge that spans the divide from the old to the new worlds. Technology has given birth to the democracy of ideas, and that may be a good or bad thing, depending on your perspective.

Passive investing is one such blossoming idea. Owning a portfolio that mimics the constituents of a published investment index, at low cost. This strategy may well become the preferable way to save for retirement. What was once seen as boring and unsexy, is now hip and trendy. The latest growth trends show that the uptake of do-it-yourself passive investing is becoming more mainstream. In the developed world, some would argue that the traditional (active) investment management industry is under siege. The passive barbarians have arrived and are pounding on the city gates. Are the active managers about to lose their lunch or their lives?

In the context of this change, it is worth considering if the uprising against active management is a good or bad idea? The uncomfortable truth is that to some degree, many successful active managers have become fat and happy. The clients of active managers have often been sold the idea that their fund managers can divine the future. Perhaps not overtly but certainly via a subtle nod and wink.

But the data does not support their inference of clairvoyance, regardless of how articulate their arguments may sound. Statistics show that on aggregate, active managers appear to charge higher fees for delivering below average returns versus broad market indices. Not exactly a compelling client proposition, regardless of how pretty the television advertisements are.

Read also: Paul Stewart: The risk of risk-adjusted returns?

So passive is a great idea right? Not so quick, because this is only half the story. Amid all the debate and marketing hype from both sides, the investor’s need is often forgotten. The principal outcome of this discussion should always be selecting the best strategy for the achievement of the individual investor’s long-term goal. The debate around whether an active or passive strategy is superior is a diversion, because actually there is no single correct answer to this perennial question.

The average investor saves in order to build a capital base capable of funding a post-retirement income need. They are not saving in order to beat an equity or bond index after costs over rolling one- or three-year periods. They are targeting a return that outpaces long-term inflation. Like their fingerprints, individual investment requirements are unique to their owner. Each individual differs and therefore their investment term, tolerance for volatility, asset allocation and required income levels will vary.

For this reason, very few individual investors are inherently suitable passive investors. The passive portfolio may not be an appropriate asset structure to match the funding of a long-term post-retirement income liability. Moreover, it is ironic to consider that the very act of selecting a passive portfolio structure including; index-type, asset class weights and risk tolerance requires making an active decision.

Read also: Satrix CEO talks Passive AND Active Investing

Not to mention the complexities inherent in portfolio rebalancing, cash flow management and ongoing income management. These are not decisions that can easily be captured in a passive portfolio structure. And let us not forget that while on average active managers underperform market indices after costs, passive strategies guarantee index underperformance after costs.

Active managers are at their best when focussing on what they are trained to do. Active management is not about predicting the future. It is rather about making educated investment decisions that carry the highest probability of a positive outcome. To add value, active managers need three core ingredients. They must be appropriately sized to take active positions i.e. not be too large. They must have repeatable investment processes that remove emotion from the decision-making structures. They also need time in order to flatten out the short-term price volatility that will be the natural by-product of their active decisions.

Passive investing certainly has its merits under certain conditions. However, the unthinking shift to passive investing is suboptimal – a bad idea in other words. Quality active managers will survive and thrive. In order to do so, active managers will need to raise their game, truly engage with their investors. Most importantly they need to provide for more individually managed outcomes, those that passive strategies simply cannot economically compete with. Active managers must also become more competitive in terms of fees.

Active managers will need to deliver simple tools, using smart technology, that demonstrate to their clients, the progression towards their investment goals. They need to move beyond simply reporting a transaction record and capital value. These tools will assist their investors to navigate short-term capital volatility, much like a pilot uses instruments to fly in bad weather. By measuring and demonstrating underlying portfolio health, investors will not be tempted to abandon the strategy when short-term losses occur.

By providing the information necessary to help each investor (and their advisors) adjust the levers and controls to their investment plan regularly, they can ensure their clients reach better investment outcomes. In this way we will build more sustainable retirement plans for millions of individuals.

We cannot be sure how all this evolution, condensed into a short period of time, will end. What we do strongly believe is that certain investment principles are timeless and enduring. Investment strategies premised upon buying good quality assets, that pay regular dividends and income and managed in a cost effective manner, will deliver sustainable investor outcomes over time. Of that we are pretty certain.

  • Paul Stewart is Head of Fund Management at Grindrod Asset Management. You can email him [email protected]