A resurgence of active asset management is imminent

Discussions about the asset management industry have been rife with talk of a permanent move away from active to passive investing. The ETF industry itself has seen an incredible $4 trillion coming their way in the last 10 years. I suspect this has been helped in no small way by the continuous strong returns generated in the broader markets globally. Who needs to pay a fund manager when you can just put your money into the S&P 500 and get a cool 14.5% annualized total return? That dream run for passive fund managers like BlackRock and Vanguard may be coming to an end, however.

ETFs are arguably one of the most crowded trades in history. Of course the case is made mostly by active asset managers. Nonetheless, with the chorus on the wonders of low fees (and apparently consequent high performance), it does begin to sound and look like one. Chasing the surging markets and encouraged by the promise of low fees, "fickle" money has flowed into these funds in large quantities. When (and it is only a matter of time) the markets turn south, I expect these "investors" to leave in droves further pushing down prices - the usual story.

The turn is coming

The US Fed is on a pre-announced plan of QE withdrawal. They will withdraw $300B for the full year ending in September 2018 and $600B in each of the two successive years. While Governor Kuroda at the BoJ's helm for another term might mean that there will be no withdrawal there, Britain and the EU are likely to be forced to follow the Fed's lead. Of course, the Fed's plan was announced mid last year and has been operational since October. The markets are only taking note now - ostensibly because of the uptick in inflation. At this, I'm constantly reminded of Jesse Livermore's learning...

I still had much to learn but I knew what to do. No more floundering, no more half-right methods. Tape reading was an important part of the game; so was beginning at the right time; so was sticking to your position. But my greatest discovery was that a man must study general conditions, to size them so as to be able to anticipate probabilities.

And the general conditions all point to a problem. Massive liquidity withdrawal by central banks on the cards. And this is money that almost surely made into the asset markets instead of the real economy*. The Shiller PE ratio in the US at a high of 32 (higher than the 27-28 levels seen just prior to the 2008 collapse). A crowded ETF trade that pro-cyclically parks money into stocks. Oh yes, we're headed down soon.

Interestingly though, when the ETF collapse does happen, the index stocks will likely suffer disproportionately as fund houses push in basket orders to pay for the redemptions. Being indexed funds, managers will have little discretion about how they finance the redemptions. Of course, those who were charging 2-and-20 for effectively running an indexed fund would be decimated as well. But among the carnage, skilled active managers should stand out and shine.

Lower fees is a good thing. But surely, creative hard-working asset managers can and do add value over a passive indexed strategy. Admittedly, this is hard when the index just goes up. But did Michael Burry add value for his investors shorting the housing bubble? When the dust settles, we should find a serious chunk of money back under the management of smart active managers.

The winners and the losers

This is not to say that the industry will not have been fundamentally transformed. The popularity of ETFs has forced investors to think hard about the value added by their managers. Adding marginal value over an otherwise indexed portfolio is no longer going to cut it and fee structures in general are likely to see a rationalization. Career-risk-averse asset managers, playing the underweight/overweight game are likely to have a hard time.

But the most creative and bold asset managers should see a resurgence. ETFs are excellent low-cost tools to express macro ideas. In the hands of a skilled active manager, ETFs can be powerful tools to create finely tuned risk-return profiles. The enhanced liquidity in these funds also reduces the cost of building a portfolio with them. This should benefit even the investors in actively managed funds.

Another set of winners could be the quant investment funds. AQR achieved tremendous scale when they packaged their offerings as mutual funds instead of the usual hedge fund structure. ETFs are the next frontier. Last year AQR (and others) asked the SEC for permission to float ETFs. If this becomes the norm, a much larger amount of money could be redirected to quantitative actively managed ETFs. One might even wonder if a "non-discretionary" quant strategy is active or passive. But at least the simplest quantitative strategies should become accessible to a much larger pool of investors.

The long and short of it

All the doomsayers who predict a demise or decimation of the active management industry are likely to be proven wrong. ETFs are a phenomenally crowded trade now - driven largely by the consistent returns in the indexes over the last 5 years. When the markets turn, there would be a stampede out of ETFs, worsening the fall. But the industry would have been changed forever.

*  A very clear indicator of Central Banks' QE money flowing to financial markets instead of the real economy is the ratio of Fed balance sheet size with the broad money indicators. As pointed out in my previous post, the US Fed's balance sheet expanded 5 times from $800B to $4.4T while the M2 money stock only doubled from $7.5T to $15T.