The symbiotic relationship between passive and active management has been highlighted in a study* by ABN AMRO’s global consulting group. No longer should they be seen as competing or mutually exclusive. They are complementary.
The paper rejects the notion that active management has been supplanted by indexation and is an approach “that has had its day”. Examining the standard arguments against active managers, it recognises these are of significant import. Looking at the issue of efficient markets and acknowledging that “if markets are efficient, there is no value to active management”, it says most arguments rely on the performance of asset managers as a group. “We just need there to be some good active managers that our investors can identify in advance.”
The study postulates ‘five phases of market maturity’, in which the fourth phase is where indexation makes its mark and gains gound. Competition among active managers forces some out, and with less money around for “stock level analaysts and company visits”, there is more mispricing, which is good for the rest.
In the final phase, a natural balance between passive and active managers persists, where “there are enough active managers to stop prices going too far from fundamental value, but not too many that there aren’t mispricing opportunities to justify the cost of fundamental analysis”. The conclusion at this point is that scope exists for active managers as a body to outperform consistently, and long-run, for active managers to do so as a group.
But how can these active managers who will consistently add value be identified? The study argues that what must be considered is the marginal risk/reward effect the manager has on the investor’s programme. “Which styles of manager are likely to have low correlations with their benchmarks?” Looking at some models of the impact of manager correlation, it comes to an “unexpected outcome” that the diversification a manager offers can be more important than their standalone risk/reward ratio. This would mean a preference for stock pickers rather than “style managers or beta-seekers”; also, stock-pickers tend to have the lowest correlations with each other. If it is accepted that performance once adjusted for style is persistent, then it is possible to find successful managers on the basis of historical information.
The study points to the ‘indexation bubble’, where the prices of index stocks are bid up, especially if there is limited free equity. When the balance moves the other way, there will be corresponding underperformance by the indexers.
In deciding about indexing portions of a portfolio, investors should note where the market is in the indexation cycle. If indexation is starting to dominate, this may be the wrong time to go passive.
Indexation is an opportunity for a good stock-picking active manager. “We should be grateful to the indexers who increase mis-pricing opportunities,” the study concludes.
*Active management: a market equilibrium, Global Consulting Group, ABN AMRO.