There has been a popular narrative that active management, the process of picking stocks and bonds, doesn't work and that everyone should just invest in passive index funds. We argue that this is not the right approach, and in fact, the more money flows into passive index funds, the more unhealthy it is for markets overall. Passive funds, as the name suggests, invest passively into an index of stocks or bonds. New inflows automatically get invested into companies at their index weights. As more money flows into passive index funds, all the companies in an index benefit, regardless of the individual company performance.
However, as passive index funds own more of the market, we begin to see several unintended consequences.
First, less discretion is used in "picking stocks," creating an environment for companies to be over or undervalued.
Second, it exacerbates volatility during market selloffs. When markets go into risk-off mode, there is less discretion in the selling, and the probability for things to overshoot to the downside increases.
Third, it weakens corporate governance, as passive funds do not generally hold companies responsible.
On the other hand, active management has not "worked" for a long time and has rationally perpetuated the move to passive.
We believe the reason active investing has not worked is due to the nature of existing incentive structures. Traditional long-only active managers are judged on their 1yr, 3yr, and 5yr returns relative to their benchmarks. This creates the incentive for the manager to try as hard as possible NOT to UNDERPERFORM their benchmark because underperformance would almost certainly kill their chances of raising capital.
In the alternative investment world - particularly hedge funds - managers are less benchmarked than traditional long-only managers. However, their fees are almost always too high, with most of the value accruing to the manager. This incentivizes managers to take excessive risk early on in their life cycle to produce high absolute returns and allow them to raise significant capital. Their incentive then changes to retain that capital for as long as possible, often leading to unsatisfactory performance.
We do not think either of these are sustainable incentive structures. We see a future where the investment world is divided into passive and active strategies, with active including what is currently considered alternative. We partner with active managers who agree on a better alignment of incentives and work to reduce unnecessary fees and intermediaries, thereby delivering more of the value created by active management to our clients.