Consolidation could well be the enemy of active management, according to SYZ Asset Management’s Katia Coudray, who warned that larger firms’ funds are less able to generate consistent levels of alpha.
The SYZ Asset Management CEO believes it is more important to be among “the best rather than the bigger”, given the increasing popularity of passive vehicles as investors become more aware of potential closet trackers.
However, as more asset management firms partake in M&A, she warned that the pooling of large amounts of capital can accelerate liquidity constraints and reduce the ability of active managers to exploit market inefficiencies or to buy into under-the-radar stocks.
“Research shows that size has a major impact on the ability to generate alpha,” Coudray said.
“The bigger a fund is, the more difficult it is to exploit inefficiencies. For example, the average size of the ten largest funds in European equities, according to Lipper, is €4.6bn. The active return generated by these ten players, over the last five years, amounts to 1.5 per cent per year, net of fees.
“However, if we take the 10 best performers in the universe over the last five years, the average active annualised return is 13.3 per cent, but the average size of the ten funds amounts to only €311m.”
To tackle this issue, the CEO said fund selectors need to start reversing the trend of bias towards large active funds. Not only this, she said that active fund management houses themselves need to reconsider their capacity controls to ensure they can continue to generate alpha.
“What the rise of passives does not represent is an existential threat to true active managers dedicated to delivering consistent alpha to investors,” Coudray continued. “On the contrary, it has created a defining hour, helping to better differentiate asset management and support the ascent of true active management in the minds of investors.
“The more the active industry identifies and addresses its short-comings, the greater it cements its long-term credibility. This means demonstrating its value and promoting true active solutions to clients.”
Following recent mergers of household names such as Standard Life & Aberdeen and Janus & Henderson, not to mention the lacklustre returns of sector averages relative to their respective indices, we asked some investment professionals for their thoughts on what is threatening the active management industry.
Performance of indices over 5yrs
Source: FE Analytics
Ben Yearsley, director at Shore Financial Planning, said: “There is a danger with M&A and larger fund houses that talent gets lost and with many additional layers of bureaucracy, fund groups get stodgy and complacent.
“However, on the flipside, how many boutiques are that well run with excellent performance? I am a believer in boutique fund management houses, however boutique doesn't have to mean small.
“Just look at Artemis as an example, £25bn AUM now but still managed with a boutique entrepreneurial mindset. Man GLG is another where managers are allowed to do their own thing in a boutique style environment.
“However, M&A itself is disruptive and often a complete pain. Interestingly I think rather than size, it is whether a fund group is publicly listed or privately owned that is more important.”
Yearsley did disagree that larger funds are less able to generate alpha, though.
“A good fund manager is a good fund manager wherever he or she is and equally capable of unearthing good quality investments whether in a large or small fund house. It's more about process and personnel than size,” he added.
Martin Bamford, managing director at Informed Choice, said M&A actually creates “great opportunities” for active fund managers, where they are able to identify acquisition targets and profit from this activity.
While he said there is less opportunity for active managers with a smaller concentration of larger companies to choose from, he pointed out the investment universe is still very large and that rising M&A activity levels should not provide an excuse for underperformance.
“It appears to be easier for fund managers to unearth alpha from mid- and small-cap stocks, so large-cap managers and investors in these funds should accept less opportunity for benchmark outperformance,” Bamford added.
When it comes to active management broadly, he said it would be "ridiculous" for investors to believe the rise of passive investing has not presented a threat to the sector.
“Active fund management is under the microscope like never before, with a big case to answer to ensure investors remain prepared to accept higher costs for the opportunity, without guarantee, they could get higher returns than those on offer from the index.
“With the asset management sector under scrutiny from the FCA and other regulators too, active managers have their work cut out in the coming years to prove their continued value.
“I suspect we are going to see index trackers continuing to rise in popularity, with active strategies under pressure to cut their excessive margins and provide better value to customers.”
Ben Willis, head of research at Whitechurch Securities, agreed with Bamford that the rise of passives has indeed presented a threat to active management.
He said: “If you are paying up for an actively managed fund then the bottom line is that the fund manager has to beat the index or benchmark otherwise they are not justifying their fee.
“As we have seen over recent years, beating the index during certain periods has been very difficult for active managers and this has put them under sustained pressure.”
While he disagreed with Coudray’s thoughts on the rise of passives as a disrupter, Willis concurred that big isn’t always better when it comes to behemoth fund groups.
“Liquidity and the ability to be flexible and/or invest in small caps can become compromised when a fund becomes too big,” he said.
“However, if you are contrarian investor, then the liquidity argument loses some of its gravitas because you are aiming to buy parts of the market that are out of favour and therefore not in high in demand. And selling them to investors after they have recovered and are in demand (if you get it right).”
Patrick Connolly, head of communications at Chase de Vere, pointed out that it is usually smaller companies which outperform over the long term as they offer greater scope for growth.
“As active funds will typically have larger weightings in mid and small cap companies, many active funds actually do outperform in the longer-term, especially in less efficient markets,” he said.
Performance of index vs sector over 10yrs
Source: FE Analytics
“Over the past decade, the only region where a passive approach clearly produced above-average performance was in North America. This is perhaps the most efficient market in the world and a region where active managers have notoriously found it difficult to perform well.”
In an article tomorrow, FE Trustnet will be considering the equity sectors with the largest proportion of assets in index trackers.