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Active investment’s real challenge has nothing to do with passive

The future of active management is nowhere near as gloomy as it is often portrayed in the press – although that does continue to shine a spotlight on the one really difficult task facing investors in active funds

14/11/2017

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

Spend any amount of time reading the financial press these days and you could be forgiven for thinking passive investment is not just stealing active management’s lunch – it has also given it a Chinese burn, pushed it head first into the sandpit and is now seriously considering administering a particularly nasty wedgie. But are things really so bleak for active fund managers? Here on The Value Perspective, we would argue not.

The mistake many press commentators make is to assume that, because passive vehicles such as index-trackers and exchange-traded funds are seeing huge inflows of money, it must follow that this money is all streaming out of actively managed investments. But as the following graphic from the Financial Times’s FTfm publication illustrates, that just is not the case.

As you can see, the charts predict all wealth looked after by the global asset management sector – both actively and passively – will grow from $78.7 trillion (£60.1 trillion) in 2015 to $112 trillion in 2020. This is based on research from PWC, which suggests this 40%-odd growth will be driven by factors such as increases in population, in life expectancy and in asset values

In other words, the available pool of savers is becoming larger, older and richer – their incomes growing as economies expand and their wealth growing on the back of rises in the value of shares, bonds and property. All these factors will naturally fluctuate over the short term but this is effectively the trend – and none of it has anything to do with people deliberately choosing to buy passive or active investments.

None of which is to suggest that, over the coming years, passive investments will not attract significantly more assets than the active management arena – indeed, that outcome seems highly likely. While passive assets may increase very dramatically, however, within that broader picture of global asset management growth painted above, there is plenty of space for actively-managed assets to grow as well.

Sure, they may become a smaller part of the overall pot but take another look at the charts above and you can see actively-managed assets forecast to grow from $58.4 trillion in 2015 to $74 trillion in 2020 – an increase of 27%. And no, we have not become any less sceptical about the impossibility of forecasting the future – it is just that, whatever the actual numbers prove to be, you can see the common sense underlying the basic trend.

So while the imminent death of active management might make for easy articles and clickable headlines, the reality would appear somewhat different … which, unfortunately, continues to shine a spotlight on the one really difficult task facing investors – how to go about actually picking an active fund manager, who can outperform their respective market on a consistent basis.

Here – among other things – we are back to the question of judging luck versus skill, which we have addressed many times, here on The Value Perspective, in articles such as Investing versus Wimbledon, Top Guns and Your starter for tenure. With that in mind, we are delighted to welcome a new voice to the debate in the shape of our new favourite blog, Behavioural Investment, written by Joe Wiggins.

While our go-to sport to help illustrate the roles of luck and skill in investment is tennis, Wiggins uses golf to highlight that there needs to be a direct and deliberate link between process and outcomes. “If I am playing golf, take aim at the flag and proceed to shank the shot, but the ball ends up in the hole after ricocheting off a tree, that is not skilful – even though the ultimate outcome is both the one I intended and positive,” he writes.

Wiggins goes on to stress the need for a large sample size to validate skill – “a single successful golf shot could be mere fortune, after 100 attempts the influence of luck is significantly reduced” – before noting:

“Identifying skill in an active fund manager is incredibly difficult – long-time horizons are a prerequisite and past performance alone does more to mislead us than guide us – but it is not impossible.”

Crucial to the task, he argues, is thinking about different types of outcomes – that is, focusing on specific decisions through time, rather than on past performance. “Given outperformance is the ultimate objective of active fund selection, it is unsurprising so much attention is lavished upon historic results,” he concludes. “Yet in a chaotic and unpredictable system focusing on such a context-free number is highly problematic.”

Author

Nick Kirrage

Nick Kirrage

Fund Manager, Equity Value

I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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