How can AM survive the move to passive indexing..

Almost everyone young i know avoid funds with huge costs. They only go for passive or very low cost funds.

This makes me wonder if AM can really survive (over a generation), if the younger people keep moving towards low-cost choices. Obviously if you are a complete baller and getting 30%> per year then you'll have no problem, but what about the average fund on the Street?

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Comments (19)

Jun 21, 2016

Since Asset Management is a broad term, just want to clarify - are you asking about the entire active investment management community (ex. Hedge Funds included) or just the large AM funds like BlackRock and Vanguard?

Best Response
Jun 21, 2016

great question, because I have to answer this question all the time, I've given it some serious thought. I hope this helps.

so you know my bias, I'm a value guy for my PA and the equity component of client portfolios, and I think index investing is a fine way to go if you don't want/need ongoing advice, aren't interested in markets, and just want to put your money in something low maintenance and low cost. it's kinda like buying a honda accord, not exciting, but it gets the job done better than most. if I had one overarching recommendation to people, it'd be buy broad based funds (index or active), do not do anything to them except contribute, and then entertain the idea of hiring an advisor into your late 30s and 40s or when you have children, your situation may have gotten sufficiently complicated to warrant advice. at this point, you shouldn't pay out the ass, but don't expect to get PWM quality advice from wealthfront or betterment.

as a whole, investors cannot outperform the market. by definition, investors make up the market, so net of fees, the "average" investor will make the market return, minus fees. many companies realize this and so decided to give up and just mirror the index. as a result, trillions has flowed to index funds of all shapes & sizes. I believe vanguard is the original, and maybe the biggest, they introduced a mutual fund for this, and it's served them well.

side note: vanguard is not a passive firm, they are a low cost firm. they use LOTS of active management in some of their flagship funds (wellington anyone?), jack bogle believes in both active and passive, but with low cost being the overarching theme. this is a common misconception.

I believe what you're suggesting (all AM that's non index will go away) would happen if all investors had the same objective: to obtain the market return at a low cost, but many investors do NOT have this as their sole mandate. many investors like insurance companies, pensions, endowments, and families have specific needs that buying a S&P or AGG index fund couldn't handle. insurance companies need to manage interest rate risk (actuaries help with this based on their underlying policies) and pensions have target rates of return, but I think the more easily understood one is families and endowments having spending needs.

I'm more familiar with the family side but I assume endowments are about the same. you have a target amount of withdrawals every year and need to produce that regardless of what the market does. if you simply buy the S&P and withdraw dividends and sell shares, you could potentially set yourself up for ruin. there's an interesting chart out there that basically says if you got the 20y from 1983-2003 in reverse order and that was your retirement, you'd be broke by year 15, even though your annual return was 13-14%. volatility matters in cases where you have spending goals, and aside from just asset allocation, many investors will opt for more dividend growth type stocks and lower beta names, ending up with a portfolio looking more like the dow than the S&P. traditional AM will have a place here.

taking that a step further, many investors of substantial size want to reduce volatility for SWAN sake (Sleep Well At Night), which is completely irrational from a financial perspective, but it is the truth. it can be because of a bad experience (I saw my money get cut by 70% after the tech bubble, and I know I don't need to earn any more, so I just don't want to see it drop as much), or it could be that they took substantial "risk" to earn the money, and because they feel married to it, they may not want to see it change. so if an investor has a volatility target less than index funds, this could require an active approach.

taking that another step further, you may be saying there are indices for that, and you can mitigate volatility with bonds, so why not just buy SPY & AGG? I feel the bond market is definitely a place where you shouldn't index as much. the simple fact that each security is different, index funds buy bonds irrespective of credit due diligence, and that trading is still somewhat done manually, unless you just want to buy the 10y, I'd say go active for fixed income. if you're a retail investor, the muni market is sufficiently inefficient that I'd never want to buy all muni index funds. also with fixed income, you may have a target time horizon (laddering), so if you go passive, your duration, avg coupon, avg credit quality, avg maturity is all at the mercy of the index. I see this of particular importance to muni investors and insurance companies.

additionally, if you want to mitigate volatility, there is a case for HF and FoF. while they haven't been doing well this year, many investors look at their portfolio as a whole, so for years where stocks are down and bonds are flat and their relative value fund did well (remember, volatility helps some HF strategies' returns), they may feel good that their money wasn't as volatile, either because they have distributions to meet, they're nervous, or just because they don't want volatility.

on the future of AM: too many times you see firms creating strategies that look like the index (google active share), for fear of losing assets. if you deviate too much from your benchmark, you will lose assets, you can watch lipper flows and see this happen. investors are people, people are irrational, so they will chase hot dots, bail when things are bad, and a whole host of other things. I think that part of AM will largely go away. the smart firms will do like BlackRock did and create and index arm so they still keep some fees, but firms that have a bad lineup and stick by it will bleed assets.

what I think will never go away is high active share managers. the trouble is it's only easy to identify quality ones in hindsight. mario gabelli, bruce berkowitz, chuck royce, richie freeman, kayne anderson, perkins value mgmt, bill miller, brandes, first eagle, etc., all have high active share strategies that will look great sometimes, and look terrible other times. I think these firms will retain what I'll call "patient money," investors with long time horizons or anyone who doesn't fire people because of quarter by quarter performance. it wouldn't shock me if institutions started constructing equity allocations with a passive + active approach.

final answer? AM will shrink, but never go away. once you see stocks start running away (after the next crash) and valuations mattering, more managers will outperform and your friends will start debating which mid cap value fund to buy. I also know fee compression is a very real concern for many fund families. their active fees will decline to get closer to index fees, regardless of outperformance.

    • 19
Jun 30, 2016

Great reply brofessor, thanks for the eye opener.

Jun 30, 2016

You hit it on the head. I'll just add that etfs work better in efficient markets, which rely on arbitrageurs (aka active managers) exploiting incorrect prices and driving the prices towards their correct value.

Feb 20, 2017

Thanks for the thorough explanation brofessor. So, quick question on the fund manager side in terms of fees. The traditional model for fees right now is 1% of AUM for active funds. What level of fee compression do you see happening (30 bps, 40 bps, etc.), and over what time horizon (in 10 years, 20 years, etc.)? And how do you feel this will affect compensation moving forward in equity space active management AM? Say the analyst who makes 170k all in now, will he/she be making 100k in 20 years (the position, not the person haha), and the PM who was pulling $1m soon be only making 500k?

I'm very interested in moving in AM equity space at funds like Fidelity & Wellington, and was just curious to hear your response. Very interested in AM itself, but concerned that the future will not be as bright moving forward

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Jun 21, 2016

no idea over how long it will take, but I know fees will come down. for example, all large cap US could be under 1%, all fixed income could be under 50bps, and so on. I would imagine that salaries would still have to remain competitive, but if there's less revenue, perhaps there are less analysts, even if the comp is roughly the same. either that, or bonuses come down. I think with NLP, PMs could learn to operate with less analysts on a team, since most start out as footnote readers.

I think there will be a place for a good analyst, but you should differentiate yourself. if I were entering the business today as an analyst, I probably wouldn't want to be pigeonholed in a large cap sector. I would want to look at high yield, municipals, small cap, or something esoteric like BDCs, convertibles, and so on. we don't need more analysts issuing buy ratings on JNJ, and while credit may not sound like a place to go given the likely upward trajectory of rates, I think it'd be a good place to be now that central banks are out of the picture and risk taking could be properly priced.

    • 3
Jun 28, 2016

To add an institutional view to the brofessor's response, a decent number of AM's that limit sector exposure to +/- 5-10% of the respective benchmark. It's a great way to mitigate macro risk and focus on security selection as opposed to larger moves. They aren't true "index huggers", but it is reasonably close.

A more significant reason that institutional investors stick with active management is that we provide a higher level of service than passive funds; even those with institutional client divisions (Vanguard etc.). We can adapt to mandate with security specific requirements (holding x% of a company's retirement fund in company stock). For some of our clients who have been with us for 20-30 years, we provide a solid point of reference, service, and integrity. Instead of just matching a basket of stocks, some of our clients like the fact that we go out there quarterly or once a year, explain our perspective on the markets, or how events like the Brexit will impact their portfolio and how we are mitigating it.

Regarding fees, it's a mixed bag. It goes without saying that if your net return after fees is a negative one; you should switch to a different manager or a passive product. But for any decent manager worth their salt, your return should still be higher than the bench for 1,3,5,7,10 - making a clear case for investing with active. You simply get more money. A good fund with lower downside and high upside-capture make it far more attractive than an ETF - they are simply better than passive.

I would say some of the new smart-ETF solutions provide an attractive hybrid for investors who prefer passive but want to capture active-type gains and even more so, lower fees.

For retail investors who think that "big banks are screwing us over" and brag that the 5k in their investment account "is in pure passive funds so I'm not scammed by the big banks in fees", passive might be the right option. I think also to be fair the movement to passive is weeding out some of the weaker funds who simply shouldn't be managing money for the returns they generate.

However, for large institutional and savvy investors, I think active AM will be around for a long time. Someone needs to make the decisions that drive valuation anyway.

    • 3
Jun 29, 2016

The value of active management is cyclical just like the market. There will periods when active management does well (outperforms) and environments where it will not. When the cycle turns (as it always does), money will follow.

Jun 30, 2016

Very substantive and elaborate posts. Cheers.

Jun 30, 2016

Alpha bro.. But seriously, fees will come down (as will compensation).

Jun 30, 2016

We will have the answer during the next bear market.

Jun 30, 2016

Question is 'will fundamental/active' survive? Short answer is 'yes' - but the long term is it is most likely declining in terms of asset growth. Partly cyclical in nature, but as AM firms continue to push more passive/factor-based/tech-based strategies, costs will go down and firms will continue to provide assets. Large AM firms (like mine) have large majority of assets in passive strategies, so yes, they will survive.

Aug 13, 2016

Passive is fine.

Active will change in time. But the best in the business will always have a job. So, you gotta become the best- and that's by starting in financial markets early and learning by losing money. You don't learn by making money, that's for sure. Anyone who says you do, doesn't trade financial markets.

Aug 15, 2016

Hedge Funds are for only high net worth investors... Most of the high net worth are not young adults. Traditional AM, now that's an interesting one.

RIP LEHMAN
RIP MONACOMONKEY
RIP THEACCOUNTING MAJOR

    • 1
Aug 16, 2016

Your first statement is not correct, but yes many young adults are not in the HF world.

Aug 15, 2016

I always thought Hedge Funds were for high nets... Well at the one I've interned at least

RIP LEHMAN
RIP MONACOMONKEY
RIP THEACCOUNTING MAJOR

Aug 20, 2016

Excellent best response above. I do see the passive argument as an increasing threat because of the prevalence of EMH thinking at universities, although behavioral finance seems to be growing in popularity to offset. People like to gamble though, and active managers will always have that element of human nature in their favor.

    • 1
Aug 20, 2016

I agree with most of what has already said. I would like to add a few points though.

In a very bullish market, it is extremely difficult to beat the markets/benchmark in the individual stock selection process. When a rising tide is rising all boats it can be difficult to determine why a particular stock is rising. Is it because the fundamentals of the business are strong? Or is it because most investors are overly optimistic? The best way to beat benchmarks in a bull market is on the asset and sector allocation. During a bear market or times of volatility; individual stock allocation abilities become much more valuable.

Also much of the data analyzing active vs passive comes from the past few years. In a declining interest rate environment it becomes very cheap for most firms to borrow, regardless of ability to pay back. When interest rates rise, borrowing becomes more expensive and the businesses with solid fundamentals will fare better than those without. This is when a manager's stock selection abilities come into play.

In terms of the EMH, I would say that theory plays well for highly liquid securities (Treasuries, Apple stock etc) and is less applicable for more illiquid markets (small caps, emerging markets etc). Just look at the sheer amount of data and analysis available for free online for Apple. Now compare the amount of information and analysis available on a small cap like Malibu Boats (MBUU).

Active fees will get compressed and the poorly run funds will be shut down. That is the effect of passive management.