The end of a binary world

As the active-passive fund debate reaches fever pitch, there is a third option, says Broadridge’s Stephanie Clarke

Despite the seemingly unrelenting growth in the global exchange-traded fund (ETF) market, active investing will continue to play an important role. Demand for quality active product is particularly prevalent in the cross-border market. But is the choice between active and passive really such a binary one?

Mapping the investment landscape

Global flows into passively-managed products totalled €270 billion in Q1 2017, further perpetuating the great drive from traditionally managed active funds to passively managed funds.

Passive funds give investors access to market beta at lower cost than their actively managed counterparts. Passive came about by allowing investors to track key stock market indices such as the FTSE100 or S&P500, but has developed into much more evolved and complex product offerings. Demand for passive products has grown considerably and with fund assets under management (AUM) now totalling over €7 trillion globally, passive now accounts for a quarter of all fund AUM.

Data from Broadridge’s Global Market Intelligence business, which covers over 80,000 ETF and mutual funds around the world, highlights how North America has shown particular propensity to adopt passive investments. Looking at the past decade in North America paints a striking picture; the average annual inflow into passive funds stood at an annualised organic growth rate of an incredible 13 percent. On the surface, the North American active picture is healthy too, with a near doubling of active fund assets in the past decade.

However, this is solely attributed to market growth, with annualised organic growth stagnant, that is, there was an average of zero inflow over the decade. Standing at AUM of €5 trillion, passive now accounts for a third of the North American funds market. The world’s largest fund is a passive fund, with Vanguard Total Stock Market Index Fund taking the crown with AUM totalling a whopping €442 billion.

North America is the world’s most mature fund market, and so, unsurprisingly, we find different dynamics in the less mature fund markets. Let’s take Asia for example. Springing from a low base, with assets representing 8 percent of the global total, growth here has been seen across the active and passive spectrum. As these markets develop, the wealth of individuals has increased and many investors have made their first foray into fund investments. Managers managing money in Asia have seen organic growth rates of 7 percent every year in the past decade. The attractive growth rates hide the complexity of understanding the diversity, culture, investment appetite and regulations in these divergent markets.

Cross-border funds: Fuelling active investment

But the real story of late, beyond the active versus passive debate, has been the rise in cross-border fund volume. In the 10 years to 2016, cross-border AUM funds more than doubled, surging from €1.4 trillion to €3.7 trillion. Underlying this expansion, index tracking ETFs and mutual funds have driven organic growth at an average of 19 percent over the same period, more than three times the rate of growth in actively managed mutual funds.

Despite this, performance in actively-managed cross-border funds remains promising. Net new money into this market in the past decade totals almost €1 trillion. There are now over 100 actively-managed cross-border funds with an AUM in excess of €5 billion—highlighting managers’ success in promoting actively managed strategies. The story behind this story is having a story.

Take the notable outlier, Nordea 1 Stable Return Fund. This fund invests in a diversified multi-asset portfolio and saw net inflows amounting to over €10 billion in 2016 alone. But, in buying a ‘stable’ ‘return’ fund, the story the investors bought into is clear. Active managers need a good performance and track record, but investors need to relate to, and buy into, the story the product tells them. As the world’s loose monetary policy comes to an end, there will be an inevitable rotation in investment product appetite. This is a key time for active managers to convince investors of their skill to navigate the choppy geopolitical waters.

Smart beta: A third way

Perhaps the choice between active and passive is not so binary. The emergence of smart beta, often seen as a hybrid approach between active and passive, is growing in popularity. Exploiting non-market capitalisation indices, devising new quantitative techniques, deploying robots, artificial intelligence and supercomputers, finding unique factors such as value, volatility, or momentum—these are all ways managers have sought to adapt to this middle ground. Priced between the alpha and beta strategies and technology driven, this is something that many managers pin their hope on as the model of the future. Managers are investing in technology and new types of human capital in a bid to find the sweet spot in this emerging investment market.

Passive investment is here to stay. Active investment faces significant challenges. But, will the third way win through? With some investors believing smart beta funds will have a tendency to underperform during periods of market stress, last demonstrated during the 2007 and 2008 financial crisis, smart beta may need a full market cycle before investors become true believers.
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