The problem with the active versus passive debate
Returns from index funds versus those of active fund managers is often debated, however Sean Henaghan, Head of the Mutli Asset Group, believes this is the wrong argument. An advocate for investing in index funds in the right places, Sean sheds light on what many are missing in this ever-present debate.
How did we find ourselves here?
It’s a question I ask myself whenever I come across an article or when I’m drawn into a discussion comparing index fund returns with the after-tax returns of active fund managers. And I’m asking it a lot lately.
As head of AMP Capital’s Multi Asset Group, the debate is usually misdirected by the time it gets to me, considering the multi-asset management process picks from different styles and strategies – including low-cost index strategies where it makes sense – to come up with a blended approach designed to meet an outcome for investors.
If anything, I’m an advocate for investing in index funds in the right place and at the right time when it is appropriate for the investor’s goals. At the end of the day, our returns are judged after fees and it’s in our interests to keep costs down as it is for any investor, financial adviser or superannuation fund trustee as long as you’re getting the right outcome.
However, as someone who works within a traditional active funds management business, I find myself addressing some of the inconsistencies in this well-worn “for and against” active versus passive argument, and invariably I’m left frustrated by where the debate ends up.
The wrong argument
The root of most of my frustration wading into this debate stems from my belief we’re having the wrong argument.
What clients really need from asset managers is to help them deliver on their financial goals. Financial goals, in my experience, are absolute and relate to growth in capital to fund retirement; they’re about delivering a level of income every year or over whatever the period may be with confidence. As investment managers, we need to be able to deliver this with certainty and with limited surprises along the way.
Rather than focus on goals, the industry has instead taken on this benchmark-aware mindset, mainly because it’s an easy way to compare ourselves to our peers.
The funds management industry, in my view, has gone so far down this benchmark-aware path we’ve not only convinced ourselves but also our clients that we’re only doing a great job if we’re beating the benchmark. We’ve created this narrative at the expense of explaining what really matters to clients, which is their goals.
I absolutely get why there’s a bifurcation happening in the market right now where clients are moving away from that middle ground I’d describe as ‘core benchmark-aware products’ where they have been paying a decent management fee in return for something that’s essentially the benchmark. It’s not great value for them.
Investors are rightfully moving away from these products into either very low-cost products or, at the other end of the scale, cost-effective but much more differentiated products where they also get value from their (typically higher) management fees.
At AMP Capital, we’re doing the same thing as evidenced by the recent changes in our Australian Equities business. In October, we announced
a repositioning of the business to focus on areas where there is long-term demand and where AMP Capital will deliver active and cost-effective capabilities that match client needs.
As much as anyone, I understand the importance of reducing costs. Our aim as an industry should be to deliver great outcomes after costs.
The problem facing the funds management industry is one of trust. As we stand here today, active fund managers are not always trusted to deliver performance because of the sins of the past where some managers dressed up essentially index funds as actively managed funds and charged 100 basis points or more in fees for the privilege.
At this point in time, the only thing clients can put their hands on and trust is cost. It’s the only tangible thing they have.
In reality, however, there are far more opportunities to deliver great outcomes for clients beyond focusing on cost alone. If we design great products to meet client goals and get the alpha component of the funds management process right, we can deliver much more beyond the savings investors are seeking by shunning active management and marching into passive funds.
More than a few things have gone right for the index funds’ narrative, which has fuelled investor demand for low-cost passive funds at a time I believe investors need active management..
What a time it’s been to own the benchmark while share markets have been driven by the actions of central banks globally printing money and leaving interest rate setting at their most accommodative. Correlations between shares and sectors have been unusually high as the market’s momentum has trumped anything earnings related.
Now, with inflation back on the horizon, and with many tipping four rate hikes this year from the US Federal Reserve, there has never been a more important time for investors to be thinking about what outcome they are investing for and which managers are best placed to deliver, rather than which benchmark they’re tracking.
I love a thoughtful discussion about the role both active and passive strategies play within a portfolio to help clients meet a desired outcome, but when the debate ends up pitting active fund performance against the benchmark I again ask myself how did we get here? And how can we change the debate so that we talk about what’s really important for clients?