The merits of active and passive management are highly debated in the investment industry. Information is now more freely available, the choice of investment products wider, technology better, and competition among fund managers greater than ever before. All this adds to the debate over the future role of active management.

To get an insider’s view of what this future looks like, CFA Society Toronto hosted Ronald N. Kahn, PhD, Global Head of Systematic Equity Research at BlackRock, to give his views on where the active management industry is heading. At BlackRock, Kahn is responsible for the research underpinning their systematic active equity products.

Three core branches of investment management

In broad terms, investment management is evolving into three branches, and it is helpful to think about active and passive management through the lens of these branches. First, there is indexing that attempts to replicate the return of a benchmark index. Next, smart beta attempts to capture market factors in a transparent and rules-based fashion, using alternative indexing strategies. Finally, pure alpha attempts to generate a positive return independent of market beta. Of the three streams, indexing is passive management, while active management is evolving into smart beta and pure alpha.

It’s hard to beat the market

The debate around active versus passive management often centres on the capital asset pricing model (CAPM) and the efficient market hypothesis, which, if they hold, would suggest that an individual cannot consistently beat the market over a period. Even if one assumes the CAPM and the efficient market hypothesis do not hold, simple arithmetic indicates that active management is a zero-sum game and that, after fees, the average active manager is likely to underperform the market. As a result, indexing has grown in popularity, gaining market share against active management. 

Kahn suggests that there are other factors that also added to the push toward passive management. Increased competition among asset managers and easier access to market research made it more difficult to outperform. Specifically, academic literature, often at the forefront of market research and identification of market anomalies, is now widely accessible and more easily replicable by firms. Furthermore, the market structure has changed, making it often more challenging for active managers to access volume and liquidity than in the past. Kahn points out that trade volume is much more dispersed. For example, in the past, the New York Stock Exchange used to make up about 80 percent of the consolidated trade volume. Now it makes up about 20 percent of the volume. 

Active management can exploit market opportunities

That said, there are reasons to believe active management can succeed. A key argument in behavioural finance showcases how people exhibit the same behaviour consistently, which provides investment opportunities for an active manager. Excess market volatility, which is volatility over and above the volatility explained by market and economic factors such as information about future dividends or expected movements in actual interest rates, also suggests there is a case for active management. And of course, everyone cannot be indexing. Otherwise, substantial information inefficiencies would develop. Active managers are necessary to exploit information inefficiencies and keep them to a minimum.

Critical trends in active management

Alternative data: data is not the edge, but efficient analysis of the data can be an edge 

There has been an explosion of available, alternative data. Alongside analytical developments in machine learning, Kahn believes this constitutes one of the most significant opportunities in active management in many years. The alternative data sets tend to be widely accessible, less structured in nature, large in volume, and high in frequency. As a result, it is not the access to the data that is an edge, but how efficiently an active manager can analyze and use the data within their investment process. It is vital that the data provides the active manager with behavioural trends before competitors observe them and well before official data sources make these trends public knowledge. 

Smart beta is a smart product development

Smart beta is another trend that has grown in popularity. The goal of smart beta is to outperform the market more cheaply and transparently. However, in Kahn’s view, smart beta is not necessarily a new investment innovation, as the ideas behind it have been around for some decades. Rather, Kahn sees smart beta as an instrumental product innovation and packaging of existing methodologies that can be delivered to clients cheaper than before. Specifically, smart beta attempts to expose key elements of active management such as value, momentum, quality, size, and low volatility. 

Only active management can deliver pure alpha 

Only active managers can provide pure alpha. Alpha is the risk-adjusted return delivered by the investment manager that is independent of beta. But delivering pure alpha is more about risk and return. Increasingly, investment managers must also consider an investor’s utility. An investor’s utility from an investment guides preferences, which in turn influence investment choices and risk constraints. One such preference would be environmental, social, and governance (ESG) considerations.

The future is more specialized and cost-sensitive 

As it stands, the future of active investment management is in delivering smart beta and finding pure alpha. The active management industry is likely to become even more specialized as access to data becomes less of an edge and the practical analysis of the data grows in importance. Lastly, there is likely to be greater emphasis on transparency in the investment process and delivering the lowest possible cost solutions to investors.