Active management has long been the foundation of a well-functioning stock market.  Many of the brightest minds on Wall Street have dedicated their careers to separating the good ideas from the bad, doing deep research to allocate capital to the right themes, sectors and companies.  The by-product for the rest of us has generally been an exceptionally healthy stock market with relatively efficient asset prices.

That foundation is now starting to crumble.  Active managers in aggregate are competing so fiercely for alpha that there isn’t much left — at least not for everyone.  The best managers are innovating, and leveraging technology so their analysts can efficiently parse through the firehose of information in search of alpha. They are separating the winning ideas from the rest to deliver long-term outperformance while controlling risks. But not everyone can win, and on average, active managers are having a hard time.

Even the best managers are not necessarily getting credit for their efforts, as the performance that a fundamental manager provides may not materialize over the short time spans over which they are commonly being evaluated. In today’s market environment fueled by low interest rates, prices have been driven up indiscriminately, making stock pickers look bad and robotic index funds look good.

Relative Performance

The simple fact is that average performance of active managers is underperforming passive management after taking into account fees, driving the public perception that active managers aren’t adding value. This simply drives more and more capital away from active management and towards passive vehicles such as ETFs.

Passive funds already own a significant proportion of equity in large cap index constituents, and that share continues to rise while the active proportion remains stagnant.  The same trend does not yet extend to companies outside the major large cap indices or those that have fallen out of a major index, and fortunately, active managers are still setting prices there.

Given that passive funds add no value to price discovery — or perhaps a counter-value by ultimately crowding out active managers’ ability to influence prices, while passive investors are daily buyers of all index constituents as they continue to attract new investor dollars — the stock picker’s opportunity would instead seem to increasingly lie outside the major indices.

Accountability

Aside from the resulting indiscriminate allocation of capital among stronger and weaker companies within these benchmark indices, making this worse is that passive investors are not positioned to properly exercise the fiduciary role of an institutional shareholder to hold companies to account.  Passives are unable to sell a stock, regardless of their sentiment on a company or the actions of its management. Moreover, when the economics resulting from their broad portfolios lead passives to generally vote along proxy advisor recommendations, this hands undue influence to third parties with no skin in the game or fiduciary accountability.

In other words, troubled companies may get a pass. With increasing passive ownership in index constituents, it becomes harder for activist investors to push companies to take the necessary tough actions, so companies will have an easier time with a large passive ownership base. Problems can build up without shareholders sounding the alarm to hold executives to account.

On the flip side, companies will start to lose the support that active managers can lend when things are not so good.  Stock prices can become even more driven by short-term financials, with the prospect of increased volatility where missed estimates or reduced guidance can lead to greater downside — without active managers present to evaluate long-term opportunity and be the buyer to the momentum short-term sellers.  

Upcoming Bear Market Opportunity

Nonetheless, there is some good news on the horizon — depending on your vantage point.  Essentially, passive investors excel in a bull market where a rising tide lifts all boats, but are vulnerable to market corrections, as they are fully invested in stocks without risk controls or dry powder cash to be opportunistic when others are fearful.  That reality is even worse for passive “smart beta”, where especially a momentum-based strategy can incur major losses in a broad market correction.

Active managers do not just manage themselves to hug a benchmark. They employ risk controls to limit their downside in the event of a market correction, and some also have the flexibility to diversify further by investing in other instruments such as credit, derivatives or private companies. This positions active managers for relative outperformance both during a correction and after, when they get to buy valuable assets at a discount.

We all love a bull market, but a coming correction may actually be the best news for active managers and the health of the market as a whole — fixing the fallacy that passive management should just keep growing and everything else will be fine.  It is this next phase in the cycle where active managers will be there to pick up the pieces on the cheap and post some of their best (risk adjusted) returns ever.

Jack Kokko is the CEO and Founder of AlphaSense, a financial search engine used by buy-side and sell-side firms. All views in this article are his own.