An often heard lament in recent years has been how the torrent of flows into passive strategies is distorting financial markets. Although this is an inevitable angle for much maligned active managers to take, it is also somewhat absurd. What is a broad, market cap index if not a reflection of the decisions of other ‘active’ investors? Passive investors will replicate the prevailing weights of the target index; active investors will move those weights*. The opprobrium directed at the rise of passive investing is mostly misguided. Indeed, it is a sharp irony that the major impact of increased indexing has been for active investors to become more benchmark aware and myopic. Their attempts to insulate themselves from the threat actually weakens the case for using them.
In an ideal world a market capitalisation index should be a reflection of the behaviour of other investors – a simple derivative outcome. Unfortunately, the market cap index or benchmark is now far more than that . It has become the lodestar for the majority of active managers. Not only is it a yardstick to evaluate quality over increasingly short and meaningless time horizons, but it has become the foundation of many investment processes. This is not because there is a widespread, philosophical belief that this is the correct approach to adopt; but because of skewed incentives and the management of business and career risk.
Active managers are under severe competitive pressure. If they don’t perform they will be removed and the money will go to a passive option, or at least an outperforming peer. Therefore their desire to take significant risk away from the benchmark is low. Active management has become like a game of musical chairs where it makes sense to hover close to the chairs at all times, rather than risk being at the other side of the room when one is pulled away.
Allied to this defensive behaviour is the closely related problem of increased short-term thinking. The threat that most active managers face of being fired tomorrow has profound implications for decision making, both for individual managers and their employers. Is there any purpose in making a long-term investment decision if there is little chance you will be around to witness it come to fruition? Indeed, making such farsighted decisions may well hasten your departure. Investing is a long-term endeavour, active management has become a short-term game.
Success in this game is based on the measurement of performance over increasingly contracted time horizons. Investors in active funds and managers of them consistently talk about results in terms of days, weeks and months. This is nonsense. Financial markets are hugely unpredictable and chaotic, and discerning skill is incredibly difficult. Over short-time horizons it is impossible.
Although suggesting so is often met with derision, judging investment quality by performance alone is deeply flawed. In a system where there can be profound randomness in outcomes, it is crucial to focus on decision quality rather than results. Performance outcomes (particularly over short horizons) are incredibly noisy. There will inevitably be periods where the skilful (or just sensible) will appear inept and the lucky will appear to be sagacious.
Judging decision quality in financial markets is fraught with difficulty, and it is far easier to use the shorthand of relative performance instead. Replace a difficult question with an easy one. More importantly, however, if everyone else cares about short-term performance outcomes, then you have to as well. There is no point playing in a game where your idea of winning is different to the other players.
Our investment behaviours pose major agency problems for active management. Listed asset manager share price performance is driven by asset flows, which are led by short-term performance . Executives at these firms are incentivised to raise assets under management and therefore become focused on near-term results. Although underlying investors are unlikely to be well-served by such myopia, the structure of the system means that executives and fund managers have to play a different game where the pay-offs arrive at a different point in time. What is rational for the manager or business, may not always be rational for the client.
We therefore exist in an environment where underperforming active fund managers are sacked, lose assets, forced to collapse their unrewarded risks and review their processes. Even if you are a talented long-term investor you might not make it through your inevitable barren spell in-tact. The result of all of these aspects is more money flowing into areas that have been ‘working’, exacerbating any perceived market distortions . Passive strategies reflect this, active strategies cause it.
Frustrated active managers will often complain that fundamentals don’t matter any longer. They do, they are just not important in the game being played. The desperation of active managers to ward off the threat posed by passive investments is leading to less differentiation and more short-term performance chasing, which only makes the case for passives more compelling. Time for a rethink.
*In this context we can think about passives as exposure to broad, market capitalisation indices. Of course, securities not captured in these can be more impacted by increasing flows into passive strategies.