The rise in popularity of ETFs in recent years, as well as the continuing appeal of mutual funds has seemingly given index-based products the upper hand in the old passive versus active investment debate. But could active management be posed for a comeback? Tanzeel Akhtar investigates…
Whenever the active versus passive investment debate rears its head, discussions about fees and performance are never far away. While index-based funds are cheaper, the performance potential of hedge funds and other active investments is greater, so the argument goes. The truth of the matter though, is not so clear-cut.
Trip Miller, managing partner at Memphis-Based hedge fund Gullane Capital Partners, says that even during a pullback, the market can still provide attractive investment opportunities, but this is when investors will start looking for something other than buying an index fund.
Miller says: “Active management tends to be more attractive when you see broad market pullbacks, like we saw in December 2018. When the market goes down, people all of a sudden start looking for something other than just buying an index – they are looking for stock pickers and people who can preserve capital in down market cycles.”
In terms of identifying a trigger for the cycle to change, Miller says a 20 per cent or more market correction wouldn’t be a bad place to start for well performing active management to stage a comeback.
Exchange traded funds (ETFs), which track a stock market index and trade like regular stocks on an exchange, are an increasingly popular form of passive investing, but they aren’t perfect in Miller’s view.
He says: “My belief is that while ETFs are an incredibly cost efficient way for investors to get exposure to the market, at some point, blind investing in an index, regardless of market-business valuation by a broad segment of the population, leads to a lot of mis-pricing.”
Miller says divergence between price and value should widen if valuations of a business no longer matter, and this mis-pricing could also lead to greater opportunity for disciplined active managers.
When compared with other investment vehicles such as mutual funds, Miller says hedge funds offer several advantages including access to alternative investment strategies.
“In general, to get short exposure, you typically have to be in a hedge fund. There are a few mutual funds that have started to do it, but frankly they don’t do it very well,” he says.
Another investor advantage, according to Miller, is the prospect of having a potentially closer relationship with a manager, in contrast to mutual fund investors who usually don’t have much in the way of interaction with managers.
Hedge funds do though, have some negatives when compared to mutual funds, says Miller, including lockups and higher minimum investments.
Ultimately, he says, choosing between the different structures comes down to performance and fees. “I think at the end of the day, whether you are a mutual fund, ETF or a hedge fund, you have to perform to retain or grow assets under management,” he says, pointing out that performance has been one of the biggest challenges faced by hedge fund managers over the past five years. And as Miller explains, if performance isn’t good, a second challenge comes into play – justifying the higher fees that hedge funds tend to charge.
“Investors tend to get frustrated faster now that they are not paying you to underperform. The divergence between the market’s returns and hedge fund returns in general has been so wide that there has been a lot of investor – and probably manager – frustration,” says Miller.
Another factor impacting managers is the so-called ‘shrinking pond’ with fewer investment opportunities to exploit. Miller says: “A problem I see in the hedge fund space is the high level of competition. The number of companies that are publicly traded today versus 10 or 20 years ago has declined significantly. The pond of opportunity in the equity space is shrinking and you have more managers looking at the same ideas, so it certainly makes it a challenge to compete and generate alpha.”
Kip Meadows, the founder and CEO of Nottingham, a fund administration firm and white-label ETF issuer headquartered in Rocky Mount, NC, explains that hedge funds had an incredible run of growth from the mid-1990s through the financial crisis of 2008. But the years since haven’t been so great for the sector.
“Hedge fund performance as a whole has never really recovered during the 10-plus years since the recovery began, so there is a market perception that hedge funds do not deliver enough in the way of excess returns to justify the additional risk and cost,” he says.
According to Meadows, fee compression in the investment management industry, led by the move toward lower-cost ETFs, has highlighted the expensive nature of hedge funds and diminished some of their appeal.
Market sentiment seems to have changed from, “I wish I had access to those hedge funds,” in the late 1990s and early 2000s to, “Why should I be paying 2 per cent plus 20 per cent of my return to an investment manager who is not outperforming the market?” says Meadows.
Investment decisions are part analytical and part emotional, and hedge funds have been out of favour in both categories for several years.
However, for investors who take a contrarian approach, or have a cyclical view of markets, it may in fact be a time for active management to make a comeback. The markets have been heavily influenced by macroeconomic and political events since 2008, with incredible overall gains in market indices.
Meadows explains that while markets have been on an overall positive trend for so long that logic suggests a ‘levelling off’ market correction, or a sideways market, could happen sooner rather than later. And that he says, will create an environment more suited to active managers.
“Active management has the opportunity to shine when markets are more sideways as relative performance amongst companies can be more important,” says Meadows.
Balance sheets and experience in navigating times of slower economic growth or recessions can also be factors that an index will not recognise, highlighting the value of active management.
Meadows agrees with Miller, and explains that hedge strategies and long/short strategies also perform better in sideways or more volatile markets. He stresses, there will always be the cost-benefit analysis of hedge fund investing.
But Meadows questions whether the higher fee structures are justified given the marginal additional return expected from a hedge fund. In addition, will the hedge fund strategy make sense in the upcoming business cycle? Hedge funds have a wide variety of investment objectives and policies, so they are not always more risky than mutual funds or ETFs, but on balance, they do, typically, take on more risk.
“There isn’t a one-size-fits-all answer as to which is better – active or passive,” says Meadows. “Like any investment, the answer depends on risk profile, other investments and where the next investment selection fits in an overall portfolio. And let’s not forget the importance of a judgement call on whether the timing is right for a particular strategy or investment class.”
