Passive investing peaks as times change
David Rogers, 15 October 2016
Could this month’s mammoth $422 billion Janus-Henderson Group merger signal the high-water mark for passive investing?
Changes in technology, regulation and central bank policies have certainly favoured passive over active investing in recent years, driving extraordinary market share growth for the index huggers.
But as the US Federal Reserve inches closer to its second interest rate rise, the European Central Bank floats a “tapering” of its quantitative easing program and the Bank of Japan nears the limits of its own stimulus programs, it’s worth considering potential implications for funds management.
Fund managers have been throwing their hands up in the air — giving up on their ability to do any better than the momentum of the market. But if CLSA is right, the stock pickers should be doing what Henderson and Janus are doing — aggressively gearing up on active investing capacity.
“Here’s an idea: what if we are at ‘peak passive’?” asks CLSA analyst Jan Van Der Schalk.
If not for the unprecedented liquidity central banks have provided via quantitative easing and record-low interest rate since the global financial crisis, investors who would have otherwise happily stayed in cash and term deposits have been forced to seek acceptable returns in equities. The multi-year uptrend in “defensive yield” and large safe stocks has made it harder for active investors to add value.
Combined with greater regulatory compliance and technological change that has facilitated the rise of “robo” advice and “thematic” investing via exchange-traded funds, the highly distorted nature of the market has certainty favoured the index huggers.
Active vs passive funds
Assets under management $bn
Source: Investment Company Institute
But what if the tailwinds for passive investing are abating? As far as Van Der Schalk is concerned, the impending marriage of two heavyweight active managers is creating across-the-board leverage to the “roaring comeback of alpha” — the excess returns of a fund relative to a benchmark. In his view Janus-Henderson is not just about cutting costs to cope with increasing regulation and compete with lower costs on the passive side of the industry.
“Do you really care about costs if you are getting outperformance?” Van Der Schalk asks. “You’ve seen a wall of cheap money flow into equities and in a rising market, differentiation has been incredibly hard. People have sought lower costs because every manager has had to deal with more regulation and better technology. But this isn’t entirely secular. At some point in the next 12 months I think we can say the tap of cheap money is being turned off.”
To be sure, quantitative easing in Europe and Japan won’t be turned off all of a sudden and official interest rates aren’t expected to shoot up around the world as weak demographics, low energy prices and technological change are expected to keep inflation low for years to come.
But at a minimum, central banks will have less firepower to deal with any shocks. The US Federal Reserve has typically needed to cut rates by about 400 points to deal with any such shocks in the past. As Chicago Fed governor Charles Evans acknowledged this week, even if the Fed funds rate regains 1 per cent next year in line with the “dot plot”, the Fed will have very little firepower at a time when US economic recovery could be considered long in the tooth. Indeed, a global “shock” could be considered overdue, even if the market has so far bucked the spectre of Brexit and Trump.
“We are facing a massive deleveraging moment when assets that have been pushed up by cheap money will come back to earth,” CLSA’s Van Der Schalk says. “As we get back to more realistic valuations, the opportunity for outperformance from stocks pickers increases diametrically. Suddenly the gap between active and passive gets huge because passive gets slammed. If active starts to outperform, where do you think the money is going to go?”
In that regard, Janus-Henderson could be smart on at least two levels.
If the “undifferentiated” period favours passive investing for a while longer, then they’ve built a defensive moat by stripping out fixed costs. Of course they could also be betting that we are at “peak passive”. If the market moves sideways, or worse still, deleverages, Janus-Henderson joint CEOs Andrew Formica and Dick Weil will have created a huge organisation geared to stock picking.
Both refused to be drawn this week on what their tie-up means for the industry, but analysts expect greater consolidation. Macquarie Group could take a look at something like Jupiter in Britain, shares of which jumped 6 per cent when the Janus-Henderson deal was announced.
Van Der Schalk says some of Australia’s biggest funds management firms could lose out because they essentially track against a benchmark and will need to “massively change their DNA” if we go back into a world where absolute rather than relative performance matters.
“The household names — the big funds — in Australia face a future where stock picking and generating significant outperformance will probably be the driver of success,” he says. “That will be a significant shift in investment style from the way they operate today.”