We have written before at length about the active to passive shift and the fact that ETFs now dwarf hedge funds in terms of total assets with over $4 trn in assets globally. It is not hard to see the appeal or rationale for this shift either, particularly as active managers have generally failed, in recent years, to deliver upon their promise of adding sufficient value over their benchmark to justify their fees. One manager in particular presented for me an “emperor has no clothes” moment. It was a boutique manager with just less than $3 bn in AUM, and a fundamental investment process focused on large cap growth. Its team of sector specialists had good pedigrees and were clearly passionate about the stocks they covered. They knew the backstories, they had conducted channel checks and listened in to earnings calls. They examined competitors and discarded them, and built and frequently re-underwrote their portfolios.
There was one problem though – it wasn’t working. This intense labor of love, and that is what it was, had not only not added value v. the index over the past 18 months, but even that value that had been added was miserly, and barely higher than the fees charged. What remained over time – and it was necessary to look back 3, 5 or 7 years to find any kind of positive excess return was hardly enough to move the needle and definitely not enough to offer reassurance to the allocator that they would, at all times, cover their fees and justify being in active management at all. I asked myself, why do these firms even exist any more? Where is the ultimate purpose, when all of that deep financial and fundamental analysis results not in value creation – but destruction?
The common refrain heard from all of these managers was that the animal spirits present in equity markets were a temporary aberration – a divergence from the normal prevalence of fundamentals in markets. Over time things had reverted to the mean – and so they would again. There were “indications” that now was precisely the worst time to shift to passive – just after a streak of under performance by active managers. There were promises that the strategy (which preferred quality over momentum) would shine in a sideways market and protect capital in a down market. Promises, promises.
I, for one, was inclined to trust them though. I shared the concern about the rapid growth of passive management and the distortions that this was presenting (c.f. the narrowness of the recent market rally). I also recalled the classic misstep of institutional investors who tend to fire a manager after a streak of under performance, only to miss out on their subsequent rebound. However, this trust came at a price. I wanted fees that reflected our purpose in investing with them – the desire for excess return. This demanded fees that were tied to excess return – performance fees – not cheap market beta.
Unfortunately, and somewhat abruptly, this manager decided to throw in the towel last week. It cited three reasons for the the decision – the shift from active to passive, the fee compression now prevalent in the industry and a personal preference for the founder to “open a new chapter” after a long career in the industry. It was a victim of circumstance, caught in the crossfire, this was not a situation of its own making. Or was it? When 30 plus people are employed, can a firm shape its own destiny? Can a firm dig deeper and cut costs, shave bonuses and put more skin in the game to achieve a superior outcome for its clients? Are there strategic partnerships possible?
There is no denying that the backdrop for active management has become challenging – it is the classic “tide going out” moment, where only the fittest firms (the hungriest, the most nimble) can have a hope of surviving. We expect to see many more outcomes like this one – which was a particularly disappointing one as the firm was women and minority run. And as the asset management industry becomes dominated by titans where does this leave the entrepreneur, the visionary and the road less traveled?