Why Investors should Pay Attention to Active Management even though Passive Investing has Grown Over the Decade

20th May, 2021

Investing, or placing money somewhere strategically with the expectation of profit, can be done actively or passively. Over the past decade, there have been enormous inflows into passive investing, leaving many wondering about the future role of active management.

Active investing involves investing in funds where portfolio managers choose investments based on their assessment of value, balanced with the risk that such investments carry. Portfolio managers typically follow a defined investment strategy very closely, as these strategies have typically been successful over historical periods, and try to outperform a certain index (e.g., the S&P 500).

Passive investors, on the other hand, usually just try to own all of the stocks in a certain market index, with investments weighted by a simple algorithm (i.e., size-weighted), rather than according to risk profile. According to Thomas Reuters, the exchange trading fund (ETF) market is increasing in size by almost 30% a year, indicating the degree to which these vehicles have captured the attention of investors.

There are a few reasons for the rise in popularity of passive growth, the first being that it is no longer inaccessible to the average individual investor. With the introduction of ETFs that span a wide variety of asset classes, passive investing has become an approach that many can actually take. ETF costs are very low as well; some charge fees under 0.1%, versus active strategies often in the 1% range or more.

Finally, given the one-way direction of the market over the past decade, many active managers have failed to keep up with the performance of passive funds, leading investors to throw in the towel on many such strategies.

So why should investors pay attention to active management? Three money managers weigh in below.

Adam Taylor, Taylor Value Capital

Why would an active hedge fund manager say he loves the massive inflows into passive investing?

Why does active investment management still demand attention amidst the passive trend?

Before I begin, let me stress that I LOVE the massive amount of money that has flowed into passive investments. You may ask, “How can an active investment manager make such a statement?”

Simple.

The more money that flows into passive investments, the more price inefficiencies will exist in the markets, and the more opportunities funds like mine will have to find and create significant Alpha.

Without diving too deeply into why inefficiencies are created and growing thanks to passive investing, simply look at what happens to any individual stock as the company gets added to any major index. It goes up, often dramatically. Yet, nothing fundamental has changed about the business other than that it is simply now included in an index, and that index has many ETFs and other passive vehicles tied to it and its underlying assets, so that passive money drives more demand and increases the price. The underlying company at that point is no more valuable than it was prior to its being added to the index. So, it is trading at an inflated valuation.

Legendary value investor Seth Klarman seems to share my thoughts. He says:  “As funds continue to flow into the hands of indexers, stocks not included in prominent indices relentlessly lag, while the beneficiaries of such inflows move more or less in tandem, sometimes seemingly regardless of diverging fundamentals.”

As far as making the decision to invest in a passive fund or an active fund is concerned, what it boils down to is risk tolerance, time horizon, and expected returns. If an investor is not comfortable with risk, has a short time horizon, and is okay with returns that match the market then investing in active funds would not make much sense. Conversely, if an investor is comfortable with risk, has a longer time horizon and is looking for returns that are significantly above general market benchmarks, then an active manager may be a better fit.

According to Ben Graham, father of value investing and mentor of Warren Buffett, “You only have two real choices: the first choice is to make a serious commitment in time and energy to become a good investor who equates the quality and amount of hands-on research with the expected return. If this isn’t your cup of tea, then be content to get a passive (possibly lower) return, but with much less time and work.”

While the traditional academic notion on investment management has been that “risk = return”, Graham believed, “work = return.” He believed that the more work you put into your investments, the higher your return should be. My firm Taylor Value Capital (TVC) in particular prides itself on working harder than everyone else and looking for investments and information where others do not.

Samer Hakoura, Alphyn Capital Management

While there has been a paradigm shift benefiting passive strategies, active management still has strong relevance and deserves serious consideration by investors. During a favorable economic cycle characterized by upward-trending markets and increasing asset values, the advantages of active management sometimes are not obvious; however, during times of volatility or market stress, active strategies are generally more appreciated as their positive characteristics are more readily apparent.

A unique feature of active management is that one can align with carefully chosen companies that come with competitive advantages and great management teams, who have a track record of excellence, high levels of integrity, and shareholder-friendly behaviour. These businesses have advantaged business models and can often outperform benchmarks over long periods of time while carrying lower risk. 

One class of companies that fits this criterion are those with what I call “synthetic leverage”.  These are companies that can safely leverage alternative third-party capital or operations to generate significant incremental cash flows, which can be reinvested at high rates of return. Such companies can compound in value for many years, especially when run by talented managers who are aligned with shareholders.

Warren Buffet is famous for utilizing this investment approach to enhance his investment returns. In addition to being a gifted investor, Buffet would use his insurance operations (particularly the ‘float’ generated from customer premiums) to leverage his returns by a ratio of 1.0 to 1.7x. This strategy was particularly effective because ‘float’ is an advantageous form of borrowing as it can’t be margin-called and can be cheaper than other forms of debt.

Other businesses that have similar characteristics can be found in public holding companies and alternative asset managers (such as KKR, for example). These businesses typically acquire controlling stakes in other companies with the objective of enhancing their value. This is typically done through operational improvements and superior capital allocation policies. 

Additionally, these companies can exploit periods of market stress or volatility, and expand their portfolios by buying good businesses when others are running for the exits. Even though the share prices of these companies can temporarily go down along with the rest of the market, often from an intrinsic point of view, these companies are usually significantly adding to their value because they are making investments in undervalued businesses that will grow at faster rates once the market cycle turns favorably.  These are the types of companies that my firm seeks to invest in.

Ryan Zhang, Standard Capital

In the age of increasing popularity for passive investments, investors are shifting away from active management due to reasons such as high cost and relative underperformance. However, there are sound arguments to make in terms of why active management should still be a crucial part of an investor’s portfolio.

One argument is recognizing that passive investing is not a one-size-fits-all strategy. Passive investments primarily track the returns generated by the indexes, which certainly cannot satisfy the wide variety of needs that different types of investors have, with their wide range of objectives and risk tolerance. For many ultra-high-net-worth individuals, the objective is capital preservation, and they also tend to be very risk averse. They do not care about market-beating returns; instead they just want to have their investments go down less than the market during turbulent periods.

For example, throughout the past decade there have been harsh criticisms against large wealth management powerhouses such as Jeremy Grantham’s GMO for underperformance, however, they still manage tens of billions of dollars!  My take would be that many of GMO’s investors are comfortable knowing that Grantham is very risk-averse and therefore their investments would probably go down less than the market during difficult times, and that is exactly what those investors want. In comparison to passive investment, there have been many times in history where active management has helped investors preserve their capital when the indexes have cratered by 30%-50%, which is certainly a dip that would be hard to swallow.

Another argument in favor is that the rise of passive investing is bringing down the cost of active management. One of the biggest complaints investors have towards active management is the cost is too high. However, because of the gradual shift to passive strategies, the cost of active management has been declining in order to remain competitive.  Some funds are now offering a “1-1.5/15” fee structure vs. the traditional “2/20” to make themselves more appealing, and others have gone as far as to eliminate management fees completely (including those I manage).

There have been many cases of incentive misalignments at larger funds where the goal is to raise more assets and collect management fees, instead of seeking returns on investments. By lowering or eliminating management fees, incentive misalignment becomes less of a concern and investors benefit substantially from a cost saving perspective and therefore increase their returns. 

About

Samer Hakoura
Prior to founding Alphyn Capital Management, Samer Hakoura worked at his family’s investment office in London and then managed various family investments in the Turks & Caicos which included the country’s main supermarket chain, where he developed processes and systems to enable rapid expansion of the business, a waste management business that won the national recycling contract, a marina, and several real estate developments. Samer started his career at Deutsche Bank in London, taking part in over $11 billion in M&A and financing transactions. Samer holds an MBA from the Wharton School of Business and an MCHEM from Oxford University.

​Samer applies lessons from managing those businesses to his selection of attractive businesses in the public markets.

Adam Taylor
Adam Taylor is the founder, CEO and Managing Partner of Taylor Value Capital, a value focused hedge fund. Adam’s expertise in investment research, executive management team assessment, valuation, transition negotiation, value creation, and identifying untapped growth comes from decades of experience as an officer and C-level executive, leading transformations, operations, strategy and M&A teams for large publicly traded companies. He has led more than $80 billion worth of acquisitions and divestitures. He often serves as a resource to CEOs and Boards of Directors looking for opportunities to create shareholder value.

Ryan Zhang
Ryan Zhang is the managing partner of Standard Capital. Ryan oversees investment research and strategies. Prior to co-founding Standard Capital, Ryan served as securities principle and equities trader at T3 Trading. Ryan started his career at JPMorgan after graduating from The Pennsylvania State University with a Bachelors of Science degree in Risk Management. Ryan currently holds FINRA Series 24, 57, and 65 licenses.

Standard Capital is minority owned and woman led. Both Ryan and his business partner are from China and immigrated to the U.S. in their late teens. More can be found on their website at standardcapitalpartners.com

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