The Benefits of Being Active

How fund managers keep investments in shape

Tim Lind, Head of Data Services, DTCC
Originally published in the August | September 2020 issue

The unprecedented volatility that began moving the markets in 2020 might finally be reversing a trend that emerged from the 2008 financial crisis: the rising popularity of passive vehicles like ETFs and index funds. While low-fee products are attractive in bull market conditions, are some sectors of the asset management industry abandoning the search for alpha and the effort to outperform the market?

When you consider the primary narrative in the marketing of financial products to retail investors in the past five years, you might think investing is only about costs. Most of the retail marketing messages are more likely to compare the cost of trading or expense ratios rather than how well their funds perform or how they help investors realize better returns. The primary message is that cost and fees are prioritized over performance. In addition to promoting low-cost passive index and ETF products, self-service propositions about access to research and sophisticated trading platforms are also being pushed, as if to say to the investor, “Here are some investment tools, good luck figuring out the market”. As investing becomes more transactional, more self-service, and less about the ability to discover value or opportunity, will there be any detours on an unsustainable race to the bottom on fees?  

According to a recent survey from NMG Consulting, financial advisers in the UK said they planned to move assets from passive to actively managed funds due to the volatility caused by the coronavirus pandemic

Reversing the trend?

According to a recent survey from NMG Consulting, financial advisers in the UK said they planned to move assets from passive to actively managed funds due to the volatility caused by the coronavirus pandemic. Nearly a third of advisers said they expected to see a rise in assets invested in actively managed funds. The same survey showed nearly 1 in 4 advisers thought passive funds would see a drop in investment inflows. 

During the market correction in February 2018, when the Dow and S&P 500 lost 10% of their value over inflationary concerns, active managers consistently outperformed passive strategies throughout the downturn. Passive strategies also benefited from a 10-year bull market where virtually all indexes and sectors saw strong performance. The old cliché that a rising tide floats all boats was certainly proven during the previous cycle; but only when the tide goes out, do you discover who has been swimming naked.  

According to MarketWatch, when markets started experiencing volatility in 2020, many ETFs began trading at prices that were not in line with the underlying securities that comprise them. Additionally, as reported by Index Industry Association, some 770,000 benchmark indices were scrapped worldwide in 2019. These trends suggest that while passive funds lowered fees for the cost-conscious public, making investing more accessible, ETFs and index funds are more complex than they seem.

It is important to remember that flexibility can be important during volatility. Passive funds are linked to the stocks contained in whatever index they are tracking. On the other hand, active managers have the freedom to choose whether to invest and can hold onto their cash when the market drops. They can hedge their bets with options or exit trades to mitigate risk. Through extensive research and due diligence, active managers can also identify those “diamond in the rough” stocks that might otherwise be missed by an index investor. When specific securities within the market are highly correlated or moving in unison, passive strategies may be the better way to go. Investors may be able to benefit from mixing both passive and active strategies.

Using data to stay ahead

Active managers looking for opportunity in volatile markets are relying on data as their primary weapon.  Sophisticated hedge funds that employ quantitative trading strategies are evolving from forecasting to nowcasting, which focuses on using data, real-time events, and processing power to predict near-term movement in markets. Recent advancements in data science and artificial intelligence further empower active managers with the ability to tap into enormous pools of data to feed their sentiment models and identify important trends and market risk indicators.

The alternative data market is exploding – web search, social media sentiment, geotracking; everything we do in modern life leaves a digital footprint – from political opinion to online purchasing habits. The winners in the active and quant space will demonstrate their ability to process, clean, and structure data for real-time analysis.  

In a volatile market, access to data becomes even more critical. Availability of tools and alternative sources of data provide new capability to active managers that were not available even a few years ago. By harnessing recent advancements in data science and AI, portfolio managers, traders, and research analysts can gain unique market intelligence to elevate their analyses. They can tap into enormous pools of emerging alternative data sources to fuel their sentiment models, helping them to identify important trading trends and market risk indicators.

Firms now have access to aggregated data on trading activity in key markets across a range of asset classes, from equities to fixed income to derivatives. They can track trading volumes broken out by security and investor type – such as hedge funds, retail wealth managers, and traditional long-only asset managers. They can examine the movement of commercial paper and certificates of deposit rates, and track position data on global credit derivatives transactions. 

The ability to harness new sources of market data can serve as a major benefit and key value proposition for active managers looking to bring in clients. That is why having access to comprehensive and innovative market data can create a competitive advantage.

Markets are always dynamic – if you take a side in the active vs. passive debate, citing performance differences over time – you will always find periods where the cycle is reversed. The impact of Covid-19 on the markets may shift the investment cycle and create more opportunities for active managers.  Dispersion has been higher in this volatile cycle, especially compared to the past 10 years, where bull-market conditions saw large-cap stocks that were highly correlated and moved more on macro news – jobs reports, political events, central bank policy, etc. Covid-19, on the other hand, created a market of winners and losers where price dispersion and relative performance of different business fluctuated dramatically. The relative fate between airline and pharma stocks amplifies this type of dispersion. The health of individual companies, and the specific effect on consumer demand brought about by the pandemic, may create better opportunity for active managers. 

The unprecedented events of 2020 provide an interesting perspective on the relative performance between active and passive portfolios under duress. When a portfolio loses 20% to 30% in two weeks, it is hard to take comfort in the notion that you were paying low-management fees. During times of market turbulence, it is essential to tap into the expertise offered by managers that look for relative value and opportunity in a new reality. Investors that look to forgo fees in favour of low-cost options could be losing out on return.