Active-Passive Debate: The Public Policy Angle
September 08, 2016
Passive investing raises many questions for asset managers and clients. A recent research paper by our sell side has stirred the debate by warning that the proliferation of passive investments should be on the radar screens of public policymakers.
With a provocative thesis, Inigo Fraser-Jenkins of AB Bernstein caught the attention of the entire industry. His paper, entitled The Silent Road to Serfdom: Why Passive Investing Is Worse Than Marxism, triggered a flurry of media coverage—ranging from CNBC to the Financial Times and the Wall Street Journal —including several critiques of the thesis. Its controversial central argument is that a Marxist economy might not be efficient, but at least it has a planning process. In a market ruled by passive investing, capital is not efficiently allocated to the most productive uses:
“[A] supposedly capitalist economy, where the only investment is passive, is worse than either a centrally planned economy or an economy with active-market-led capital management.”
Dangerous Side Effects
Of course, passive management offers benefits. In particular, it lowers costs for clients, as Fraser-Jenkins acknowledged in the report. Yet the rise of passive as a powerful market force also has dangerous side effects. That’s because active management actually serves a social function in global markets by allocating capital to industries and companies that play a role in developing an economy. The problem with passive is that:
“Rather than looking at the real economy and seeking to understand its future development, passive allocation self referentially looks to the financial economy to inform its asset allocation choices.”
Focusing on Fundamentals
In other words, active management is ultimately about focusing on the fundamentals of the real economy in order to find companies and stocks that can deliver returns to investors. Passive investing isn’t looking at the real economy at all—it’s focusing on the financial economy, so capital flows in and out of sectors for the wrong reasons. In a passive world:
“…capital inflows will be greatest when past performance has been highest, which is itself unrelated as to whether the past performance is warranted or not.”
The mining industry provides an important example, writes Fraser-Jenkins. Since it is systemically important to economies—and very capital intensive—mining requires an efficient capital market. Yet today, many mining companies don’t raise money directly from the equity markets. Instead, their market capitalization will determine how much debt they can raise to support spending and capital investment. Passive investing can influence huge changes in their market values, thereby undermining these companies’ ability to spend and invest for the future needs of an economy.
Passive Distortions Today
Some of the concerns that Fraser-Jenkins raises about passive-induced flows are reflected in markets today. For example, our portfolio managers have focused on the risks posed by popular high-dividend-yield US stocks, which trade at extremely elevated valuations and could be vulnerable if the crowded trade reverses. Similarly, investors have been chasing past performance in US utility stocks, while US healthcare stocks have been pushed into a downward spiral amid political concerns that don’t necessarily reflect their future ability to grow in the real economy. Passive indices often reflect market distortions and bubbles, such as their high concentration in technology stocks before the Internet bubble burst in 2000.
In emerging markets, passive investors today will find themselves in benchmarks that are invested disproportionately in countries growing slower than average. And the MSCI China Index holds 51% on state-owned enterprises, which tend to have fairly poor corporate governance and suffer from heavy government intervention.
Benchmarks are also flawed in fixed-income markets. When you buy a passive strategy that tracks a bond index, you’re lending money to the biggest debtors, which isn’t always desirable. High debt levels—for a country or a company—can be a sign of trouble. A default—or even a ratings downgrade—could mean large losses for index investors.
Exploring Fresh Perspectives
These are risks that can’t be ignored. In our view, investors need to be aware of all of these potential hazards when weighing the pros and cons of making an allocation to passive or active investing. Fraser-Jenkins has added another important aspect to the debate by saying that policymakers must pay attention to the growing role of passive funds, because asset managers are a major force in the way capital is allocated. Less efficient capital markets could harm long-term economic growth, so we think it’s important to study and address these issues.
While the thesis is controversial, it is certainly thought provoking. As asset manager and financial blogger Joshua Brown wrote: “…we can all agree on this—the issue of active management’s value to society is a complex one and won’t be satisfied with easy answers.” As our industry evolves, we believe exploring fresh perspectives on the active-passive debate is essential for asset managers to find the best ways to meet client needs in the future.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.