The evolving state of the buy side (Blog articles)

The evolving state of the buy side

A Bloomberg Special Report

Adapting to a new normal

Investment managers have always had to contend with a complex mix of messy, dynamic factors that impact portfolios, but the present selection seems uniquely combustible and difficult to predict. In addition to the age-old concerns of economic cycles, interest rates, and fiscal policies, managers today are also contending with a host of new considerations and concerns.

Global political uncertainty, regulation and tax-reform are just a few factors unsettling the market, at least for the short term.  Additionally, the active vs. passive debate is upending the industry, as investors pulled more than $380 billion from actively managed mutual funds while pouring almost $480 billion in passive investments in 2016.

As part of Bloomberg’s inaugural Buy-side Week 2017 New York, industry leaders and experts from across asset classes and geographies gathered to weigh in on some of these more pressing issues and contemplate how asset managers today must adjust to the new normal. 


 

 

MiFID II’s potential impact on U.S. firms

How can firms become "MiFID II friendly"?

When asked whether they had heard of the EU’s Markets in Financial Instruments Directive overhaul (“MiFID II”) scheduled to go into effect in January 2018, virtually everyone in a packed auditorium during Bloomberg’s inaugural Buy-Side Week 2017 New York event raised their hands. This is the good news.

Unfortunately, the same number of people also raised their hands when asked how many needed an overview of the new regulations. Nearly two-thirds of those responding to a survey during the event said they believe MiFID II will have “direct or indirect” implications for buy-side firms, highlighting the conundrum facing many U.S.-based financial professionals just six months before the law’s implementation. 

 

Most know about MiFID II, and most believe it will impact them in some way, but few have a specific plan to become “MiFID II Friendly.”
 

 

Broadly speaking, MiFID is a far-reaching series of European Securities and Markets Authority directives aimed at improving transparency, regulation, compliance and supervision of banks, asset managers, broker-dealers, research providers, and trading firms across the EU. The goals are laudable – increase investor protections and prevent another financial crisis – but MiFID II regulations are extremely complex and implementation requirements are extensive.

MiFID II only directly impacts EU investment firms. The UK is going a set further by gold plating the regulations and applying them to UCITS (Undertakings for Collective Investment in Transferable Securities) funds. Thus, at first glance, that MiFID II’s new rules on price transparency to the strict unbundling of research from trading commissions will only impact U.S. firms with European offices. But it’s not nearly so simple, says Bloomberg’s Market Structure and Regulatory Policy Strategist Gary Stone, because even though a U.S. firm may not fall under the MiFID II umbrella, their EU counterparties and competitors do.

“This is not just an EU problem,” Stone said. “The U.S. buy side needs to talk to their EU investors and EU brokerage partners and determine if they need anything so that they can be compliant with MiFID II.” For example, EU investors may demand the same transparency and disclosures from the U.S. active managers that they receive from the EU-based active managers. This may mean that U.S. managers may have to create an order execution policy disclosing how their U.S. desks approach executions. They may need to demonstrate through transaction cost analysis or execution price fairness benchmarks that they are taking all sufficient steps to achieve best execution. Failure raise current transparency and disclosure standards could become a competitive issue when seeking new mandates and/or result in a loss of current mandates

Though not a regulatory requirement in local markets, EU investors may look at MiFID II requirements such as “immutable storage” of books and records and taping trading desk phones as a required best practices for today’s operating environment. Firms should begin to examine, “How are we stacking up against a MiFID II compliant competitor when the discussion turns to best execution practices or use of client commissions to pay for research?” If competitively, MiFID II becomes the global best practice, Stone asks, “your investors and customers may hold you to that standard – and if you decide not to, do you risk coming up short.” 

U.S. buy-side trading desks investing in EU assets will be operating in a new market structure where they will constantly have to evaluate whether pre-MiFID II trading strategies provide similar execution results as in the post-MiFID world.

For example, U.S. traders need to be aware how they communicate with their EU brokers and pay particular attention or order size. The new pre-trade transparency regime requires trading venues and brokers that deal often and have a large market share in certain instruments to make their pre-trade firm prices publically available.

 

There are certain waivers – for example pre-trade prices in block sized trades do not need to be broadcasted. “Asking for a price on $49.8 million in 10-year Bunds could be different than where are you on $50 million because of the block threshold,” Stone noted. “Knowing that the price will be publicized may work against you.”
 

 

Meanwhile, a broader consideration to the EU’s new rules is whether there will be a competitive disadvantage to not complying with MiFID II directives. “There is a question whether MiFID II’s rules, or some version of them, will become best practices in the U.S.,” said Stone. “Rules around transparency, trade reporting and research may leave non-compliant firms out in the cold when dealing with new mandates. 

Trump’s impact on financial policy

How can “America First” impact your portfolio?

Six months into President Donald Trump’s first term, many investors are still trying to figure out exactly what his policies will mean for their portfolios.

So far, the surprises have come from the administration, not the markets themselves; the “Trump bump” in U.S. equities and bond yields following the election was a classic example of risk transfer from strong to weaker hands, and stocks continue to discount Trump’s broad mix of policy initiatives on taxes, infrastructure, healthcare and regulations.

Rate markets, though, are another story. Benchmark 10-year U.S. bond yields soared after the election in a broad shift to risk-on trades, but have since ratcheted back down again on the realization that Trump’s policy initiatives will be harder to implement than initially thought. With equities at record levels and U.S. bond spreads back near 2016 lows, resolving this “rates versus risk” question will be a central feature of second-half trading.

“The biggest impact from Trump’s agenda will be tax policy,” said Henry Peabody, a portfolio manager for Eaton Vance. Attendees to Bloomberg’s inaugural Buy-Side Week 2017 New York event in early June heartily agreed, with nearly three-quarters choosing tax reform as Trump’s biggest opportunity to enact policy change. But it’s going to be a wild ride, Peabody cautioned.

“The market is setting up for some fireworks in the next six to twelve months,” he added. “We have a market [full] of deep pocketed, price insensitive buyers of U.S. government bonds.
Unfunded tax reform will bring much higher rates as we become price makers instead of price takers.”

 

A large swath of the bond market is wrong-footed, Peabody contended, for the day when volatility rises, although for long-term investors the combination of higher nominal yields with better growth and lower taxes will be a great situation.

Importantly, attempts to rewrite the tax code will need to tread carefully around things like the deductibility of interest costs, on which much corporate investment relies and is at the core of private equity and M&A activity. Instead, Peabody expects incentives aimed at investment, such as expensing capital expenditures, which would improve the U.S.’s lagging productivity growth and result in a greater long-term shot in the arm for the economy.

"The biggest impact from Trump's agenda will be tax policy."

– Henry Peabody, Eaton Vance

For the moment, Wall Street is largely taking a wait-and-see approach to tax reform because many of the ideas being floated by Republicans, including dramatically lower tax rates, a border adjustment tax, and a one-time levy on repatriation of $2.5 trillion in foreign profits held by U.S. corporations overseas, remain vague.
 

Meanwhile, Trump’s “America First” slogan is also being felt in foreign affairs and trade policy, and there is a growing consensus that U.S. isolationism will not be a positive for the dollar. “The gap will be filled by China and Europe, which will be a stronger institution for the near term,” argued Peabody. The prospect of broadly lower U.S. influence in the world raises long-term questions about the U.S. dollar’s role as a reserve currency, and leads to a higher euro, while putting a persistent bid underneath emerging markets.

But not all “America First” steps will have immediate consequences for investors. For instance, Miller/Howard Investments portfolio manager, Michael Roomberg, who manages Drill Bit to Burner Tip (DBBDX), an energy mutual fund, believes that while the U.S. decision to withdraw from the Paris climate agreement was geopolitically dramatic, it won’t have much of an impact on the energy sector. “Energy analysts aren’t scrambling to change their estimates for oil, gas or coal as a result of Paris,” he said.  “It’s more of a global leadership issue than an energy one. At current gas prices, clean coal is fiction. No investor is going to risk money to build a multi-decade coal plant when this administration may only be there for four or seven years.”

 

That said, Roomberg agree that energy now has a friend in the White House, which could have strategic consequences for the sector. “The shale revolution happened during the Obama administration, but not because of Obama,” he observed. “The best policy is anything that increases demand, and there is probably no better way to create skilled labor and lower the trade deficit than liquid natural gas (LNG). We have six LNG facilities under construction in the U.S., with each one supporting around 10,000 jobs. It’s one of the few things the U.S. can make that is cost-competitive with the rest of the world, and Rex Tillerson is very aware of this.”

Both Peabody and Roomberg agree that for Wall Street, the elephant in the room is reform of the Dodd-Frank Act, one of the centerpieces of Trump’s effort against regulatory overreach. Despite the early June passage of a House bill repealing Dodd-Frank, neither expects a wholesale rollback to pass the Senate soon. At the same time, rewriting many of the rules put in place to implement Dodd-Frank, including those related to the controversial Volcker rule limiting prop trading, would require coordination between any number of five different government agencies - the Fed, FDIC, the Comptroller of the Currency, CFTC and SEC – in a process that would be neither simple nor quick. Reforming Dodd-Frank “is a big mountain to climb,” said Peabody. “No one is changing their business models based on changes to Dodd-Frank happening anytime soon.”
 

 

 

Geopolitics: What’s the world coming to?

Ask portfolio managers these days about what keeps them up at night, and the answer is likely to be surprisingly consistent: geopolitics. Wall Street’s more pedestrian fears – the Fed, the economy, regulation, etc. – have been superseded by worries about an increasingly fluid and interconnected set of global hot spots.

Indeed, at Bloomberg’s Buy-Side Week 2017 New York event, a whopping 74% of those attending a panel on global asset allocation picked geopolitics as the element that poses the single greatest risk to their baseline forecasts. And even more telling, those traditional areas of concern, such as a slowdown in economic growth, or monetary and fiscal policy, barely polled above 10%. Regulatory risk, which loomed so large just a few years ago, didn’t even register. Geopolitics has always been on the radar of portfolio managers, but the risk of being blindsided by some geopolitical curve ball clearly weighs more heavily on their minds these days.

That said, it is important to delineate between what is a risk for the world and what is a risk for your portfolio. In the former case, the chance of a miscalculation with China in the South China Sea seems to increase by the day, while North Korea has been consistently described as the “single greatest threat” facing the United States by a wide range of senior U.S. government and military officials on both sides of the political spectrum. Meanwhile, a host of smaller regional fires simmer – Syria, ISIS, Venezuela, Iran, etc. – below the surface and, at least from a portfolio manager’s view, have the potential to flare up at any moment.

That’s where a key distinction lies. For portfolio managers, a key question is not whether risk in a region or country exists, but whether it is appreciably more or less than what is considered “normal” and thus already reflected by asset prices. Tension in the Middle East may be rising at the moment due to the dispute with Qatar, but it’s the same hot spot it has always been – no portfolio manager is going to suddenly realize there is geopolitical risk in that region and start to hedge. Same for Venezuela, which has been locked in a long, chaotic descent towards disintegration – no surprise there.

In contrast, risks that could swiftly and specifically impact a portfolio are much more nuanced. China dominates this discussion as well, according to Bloomberg’s polling during Buy-Side Week. Replying to the question of which region holds the most investment risk over the next year, 30% of respondents chose China, followed by the Middle East at 20% and, surprisingly, the United States itself at 14%.

This latter point is partly because U.S. trade policy under President Donald Trump is now a much more visible geopolitical topic, noted Gary Huffbauer of the Peterson Institute for International Economics. And a protectionist U.S. brings a relatively novel set of considerations to the table that few active on Wall Street are old enough to remember.

Moreover, added David Dollar from the Brookings Institution, this shift is occurring relatively late in one of the longest credit cycles on record at the same time as the new administration is promising tax cuts and heavy investment into infrastructure. As a result, while it will be tempting (and politically expedient) for some to blame the onset of higher deficits and rising interest rates on poor trade relations with China and others, they are also the result of deep macro and fiscal trends.
 

 

For investment managers, Hufbauer and Dollar agreed that China’s complex mix of threats is the largest geopolitical challenge at the moment. As it relates to Wall Street, they outline three what-if scenarios that pose the greatest threat of escalation: An uncontrollable capital outflow driven by a 10%+ devaluation in the renminbi, a collapse of China’s shadow banking system, and an implosion in China’s rickety real estate market. And, as one would expect, all three are intertwined such that the arrival of one probably sparks the onset of the other two.

And the biggest geopolitical risk your average portfolio manager is probably not focused on? Emerging market debt levels, according to Dollar. The substantial rise in emerging market debt since the financial crisis has been driven by developed-world ZIRP and NIRP monetary policies that induced the issuance of trillions in dollar-denominated debt encouraged by an insatiable global demand for yield. In the rush to take advantage of the situation, total emerging market debt skyrocketed to a total $56 trillion last year, or 216% of emerging market GDP, according to the Bank for International Settlements. Indeed, emerging markets raised nearly $40 trillion of debt between 2006 and 2016, compared to the approximately $9 trillion issued in the ten-year period beforehand.

The problem? As U.S. interest rates go higher, that debt will become increasingly burdensome and vulnerable to exogenous shocks from commodities, currencies or global events that send investors fleeing to safe havens. Meanwhile, EM debt is increasingly priced to perfection – yield spreads between US dollar denominated EM corporate debt and similarly rated U.S. corporate bonds has hit record lows. 

Those on Wall Street a little long in the tooth will recall the kind of contagion that can occur when overbought emerging market debt markets collapse. This time around, the structural conditions in and around EM economies are stronger, reducing the likelihood of an EM-sparked financial crisis a la 1998. Nonetheless, from a geopolitical perspective, the risks with the lowest probabilities often end up having the greatest impacts precisely because they are largely ignored.

 

Quant strategies and the future of trading

The combination of rapidly increasing computing power for steadily decreasing costs has placed robust quantitative strategies within reach for more investment managers than ever before. Simultaneously, extremely low volatility is increasing the demand for computer-driven strategies that are able to systematically crunch exabytes of data to find an edge, while the types of structured and unstructured data sets are also expanding.

These trends are resulting in increasing capital flows to quantitative hedge funds, which commanded 17%, or $500 billion, of total hedge fund assets, according to Barclay’s.

Nonetheless, with technical tools easier and cheaper to build and implement, their use has skyrocketed.

43% of respondents to a survey during Bloomberg’s inaugural Buy-Side Week 2017 New York said their firm uses quant strategies for risk management and/or portfolio construction, while another 22% employ them in factor or risk-premium strategies. Only 6% admitted to having no interest in quant at the moment, and 12% are evaluating quant strategies for possible use.

There are two major distinctions to make when discussing quantitative trading notes Maria Vassalou, Partner at Perella Weinberg Partners and Portfolio Manager for the PWP Global Macro strategy. 
 

 

The first delineates across the holding period of the trade, i.e. from high frequency trading to several months. The second refers to the type of information used to inform that trade, i.e. technical, fundamental and everything in between. Wall Street began its quant love affair with the former: the high-frequency trading (HFT) craze of the 1990s. Today, it is increasingly concentrated on the latter.
 

 

This shift is occurring partly because there are only so many nanoseconds you can squeeze out of a trade, but also because extraordinarily large amounts of previously uncollectable data are now available quickly and cheaply and can be processed in the cloud equally quickly and cheaply. Both open up ways of doing things that weren’t possible before.

The second distinction is using quant as a tool versus using quant as a strategy. An algorithm that systematically manages multiple types of risk in a portfolio is a tool; one that systematically places trend-following, high-frequency trades is a strategy.

In each case, use of quantitative methods is growing across the board, and it is raising not only clear use cases in which quant approaches are best suited, but also questions about the risks they pose.

“A quant approach allows you to do things otherwise not possible as an individual portfolio manager,” said PWP’s Vassalou. “Humans can’t compete in HFT and intra-day strategies, for example. For longer-term strategies, a quant approach can help provide discipline, risk management, verify your strategic thinking, and help confirm your portfolios have been structured correctly.”

 

Another advantage often ascribed just to HFT but applicable to quant-driven investing as a whole is an increase in liquidity. The low cost and high speed made possible by these tools has helped lower costs and tighten spreads. Consider: twenty years ago, the spread between the bid and ask of a major U.S. blue chip like General Electric was $0.20-$0.25 per share. Now it’s a penny, and often less than that in the HFT world. Granted, this hasn’t been good news for the brokers that relied on those spreads for revenue, but there is no denying it has led to tighter, more efficient markets.

At the same time, the rise of systematic managers is reducing the speed it takes for the market to find fair value. “Brexit and the Trump election are examples of events that would have taken days to work through ten years ago,” said Bill Harts, CEO of the Modern Markets Initiative. “Instead, they were flushed pretty much through the system in a matter of hours. Algos mean news and emotion are reflected much faster and to a much greater scale.”

As quant involvement grows however, there a growing concern about whether it becomes harder to generate alpha by using it. For example, the first person to study satellite photos of Wal-Mart parking lots generated an undeniable advantage from it. But once everyone studies the same data, there is no advantage, and thus less alpha.

Another fear is that quant strategies will crowd out the need for humans. That’s absurd, said former Bridgewater Chief Business Architect, Jeff Wecker. “There are plenty of opportunities for humans to deploy these ideas and tools, see greater applications and use new sources of data.”

"Before there was artificial intelligence, there was real intelligence."

–Jeff Wecker, ex-Chief Business Architect, Bridgewater Associates

PWP’s Vassalou agreed. “It is misplaced to think humans are out of the picture. The fact is, you still need intuition, knowledge about relationships, history, etc. Alpha requires nuance as well as data. It is not just technique.”

Interestingly, a more recent concern coming out of the quant space comes from having too much data. “Good algos start with a hypothesis, then test using the best and most complete data possible,” said PWP’s Vassalou. “But we’re seeing quants starting with data, and then looking for a hypothesis to fit it, which is very dangerous. They are solutions looking for problems.”

Ultimately, the real value may come when really great quant techniques are paired with really smart people with a lot of imagination. “Large shifts in underlying issues may make an algo ineffective until it can be tweaked,” said Wecker. “They’re not built to handle wide departures from the status quo. There are no black swan algos out there.”

The implications of machine learning in finance

Machine learning may not be in your firm’s toolbox yet. In fact, according to a survey at Bloomberg’s Buy-Side Week 2017 New York event, only 16% of firms have incorporated any kind of machine learning into their investment strategies. Meanwhile, the remainder is either researching ways to do it (24%), would like to learn about how to do it (26%), or hasn’t even thought about doing it yet (32%). Yet if Bloomberg’s head of Machine Learning Gary Kazanstev is right, machine learning is coming to every firm soon enough.

 

Despite being the buzzword du jour on Wall Street these days, machine learning is still fairly misunderstood. It is not artificial intelligence (AI) itself, but rather a form of it in which computers fed extremely large data sets are

able to learn as changes in that data occur without being explicitly programmed to do so.
 

 

The data is just one part of the approach, Kazanstev said during a panel at Buy-Side Week in June. What can be more challenging is making machine learning and data science a core capability among companies so that they instinctively take internal and external data sets and interpret it for patterns, risks, opportunities, and so on.

And like all things tech, the space is evolving quickly. “The level of expertise in machine learning has risen rapidly,” Kazanstev added. “It is shifting to engineers and quants as your counterparty in the discussion, not investing personnel.” The data is shifting too, from structured data like prices or economic statistics to unstructured data mined from new sources of information, like GPS coordinates and social media. All of it is anchored on an increasing ability to bring tremendous computing power to bear for very little cost.

“The key process at first was simple automation,” Kazanstev explained.


​“But at this point, throw a dart at any investment process and someone, somewhere has automated every part of it.” Now, that power is being directed at more subjective things.
 

 

“Four years ago Twitter steams were being analyzed for simple binary interpretations of bullish or bearish,” noted Mac Steele, Director of Product at Domino Data Lab. “Now, it is much more complex. Five years ago, satellite image analysis would have taken three months and millions of dollars in capex; now, it takes a fraction of both.”

The cutting edge for machine learning applications is combining experience with statistical data to develop uses, so image processing in general is a hot topic, continued Steele. “There’s talk that merger arb firms are even doing facial recognition to match who walks into target firms. This is the kind of activity going on now because it’s no longer hard or expensive to do.”

The ability to crunch tremendous amounts of data is showing up in other areas. “In text analysis, we are figuring out how to determine whether a CEO is being evasive on a conference call,” added Bloomberg’s Kazanstev. “And it’s not just from audio – you can ascertain this from text now as well.”

In these silos, the data itself is less important than what the system does with the internal/external data it gets, and how it treats subsequent inputs, interpretations, and patterns. Iteration of the data, and the frequency with which it occurs, is becoming a primary lever, because each successive round makes the overall system smarter.

For the buy side, these applications take two approaches, Kazanstev explained. “With humans, we are inverting the workflow from managers asking for things to pushing information to them based on their profile or behavior, stuff they would not even know to ask for. On the enterprise side, “black box” consumption is differently optimized and involves human in-the-loop automation. All of this also provides feedback to a suite of learning algorithms, which all adjust accordingly in time for the next set of data.”
 

 

Machine learning is also making dramatic inroads in data visualization, or tools that make it easier to ask very complicated strategy or scenario questions involving a large number of unstructured variables. “The appetite in financial services is for the solution, not the algorithm,” noted Steele. “Therefore, these things are judged on their efficiency gains, not on the product or application itself.”

Meanwhile, limitations do exist. For instance, if there is a bias in the data, it may be hard-coded into the machine learning application that uses it. These tools can learn, but that learning is bounded by the basic parameters introduced by the humans that made them. “If the data is biased…and most is…by habit or convention, the resulting output will be skewed,” observed Kazanstev.

Finally, both Kazanstev and Steele agreed that the ultimate debate on machine learning will revolve around data privacy. It is of paramount concern, particularly in Europe, and could constrain advances. “The goals of artificial intelligence are in many cases fundamentally at odds with the goals of privacy,” said Kazanstev. “Data is a core component to both, but one needs complete access while the other wants restricted or no access.”

“There are a lot of opportunities for machine learning to co-exist with privacy regulations,” observed Steele, “but we have to be careful. It won’t take many scandals to turn public opinion away from ‘the machines’.”

 

The future of active management

Is the expense ratio the new performance chart?

There are few topics on Wall Street that rival the debate raging about passive versus active investment management. Like religion and politics, it’s become one of those subjects that one tries to avoid in polite gatherings.

The conventional wisdom, dating to 1973 and Burton Malkiel’s dart-throwing monkeys, holds that most money managers are no better (and often worse) than the broader market in generating portfolio returns, yet charge high fees. And in the past few years, it’s true that many active managers have struggled to consistently outperform their respective benchmarks. But the argument of active versus passive is actually much more nuanced than meets the eye.  
 

 

Some figures to set the stage: According to Bank of America Merrill Lynch, $3.1 trillion has flowed to passive bond and equity funds, while $1.3 trillion has flowed out of active bond and equity funds since 2007. This is a colossal amount of money when considering there is about $10 trillion parked in active versus $5.8 trillion in passive funds (defined as index funds and ETFs), and starkly illustrates how much capital is abandoning the idea of an individual’s ability to beat the averages. 

This trend is likely to continue. Passive funds currently make up around 33% of total U.S. mutual fund assets, but when asked where this figure would be in five years, a whopping 72% of attendees at Bloomberg’s inaugural Buy-Side Week 2017 New York event in early June said passive would command 50% of assets by then. On the low end, that’s another couple of trillion dollars. But there are a number of other factors at work than just mediocre returns in exchange for high fees.

 

First, the environment of the past decade has favored passive funds because of extremely low volatility that has made it much more difficult for a manager to generate true alpha. Even if a manager does guess right, in a low-volatility world, he or she will struggle to deliver much versus a benchmark.

But that environment is changing. Interest rates are rising again and a host of crisis-era responses like ZIRP and QE are being phased out. The next five years are likely to see tighter monetary policy and greater volatility, meaning they are likely to be better for active managers than the last five. “In a more normal environment, the entire equation shifts,” said Jonathan Golub, Chief Equity Strategist for RBC Capital Markets. “Value stocks, small-caps, and international stocks will do better. We could be entering a period in which active kills benchmarks.”

Another important point is the broad price deflation that has afflicted a range of industries, not just asset management. This “great cost migration” exists in the broader economy and has been the mother of all trends since the crisis. It overshadows the active versus passive debate, with even low-cost passive losing assets to lower-cost passive. 

“The whole active versus passive debate is arguing about the wrong thing,” added Memani. “The debate should be about whether certain active managers can deliver value or not. If they can deliver value, the market will gravitate to them...otherwise flows would be going only to passive funds. But they’re not - actives that have been able to outperform or deliver value, have been able to gather assets.”

Thus the challenge for active managers is three-fold. They have to manage, at least for now, in a low-volatility environment that discourages wide return dispersions, deliver value significantly higher than the price they charge, and do it in the context of a highly price-sensitive consumer. Those that do can expect to attract assets.

A third factor behind the scenes is whether active managers pursuing esoteric or sophisticated strategies in less-efficient parts of the market are more valuable. “Passive replication of a model or asset allocation strategy with a low-cost ETF or index fund is easily possible in deeply liquid areas like large cap equities,” explained Memani, “but not in all areas, like bank loans or emerging markets.”
 

 

However, it may not be so simple. Assets have increasingly flowed to passive products designed with specific purposes in mind, instead of strategies. “The growth in passive assets is increasingly goal-driven, not structure-driven,” countered Jim Rowley, Senior Investment Strategist for Vanguard Investment Strategy Group. “They aim for a solution, like principle protection or a retirement date, instead of trying to beat some benchmark by 100 basis points.”

“The active industry did a disservice by teaching the investing world that the only value of an active manager is beating a benchmark,” Rowley continued. “The real growth in assets is in solutions-based products. For these investors, whether they use active or passive is more of an implementation issue, not a philosophical one.”

For now, the debate continues. “It’s a fact of life - low cost beats high cost,” Rowley declared in a statement that is certain to make active managers twitch. “And every basis point in fee means one less basis point of return.”

The future of active management: Part II

Structural implications of the active vs. passive debate

The surge in assets devoted to passive investing since the financial crisis has been partly driven by an explosion in the number and breadth of index-based products available to investors. Gone are the days when investing in a passive fund meant just buying the SPY and going back to sleep.                   

Now, the speed and spread of information, aided by tremendous computing power available at very low cost, means the indices against which passive investment funds benchmark themselves have become increasingly specialized, and there are now more index funds and ETFs than listed corporate equity securities. This raises a host of questions. 

At first glance, one might think the greater the choices, the greater the competition and thus pressure on fees. To some extent, this is happening, especially among the more commoditized flavors of broad equity and bond market proxy funds. But the trend towards more passive vehicles than listed stocks begs the question of whether returns will coalesce around the lowest common denominator when everyone congregates into an ever-shrinking pool of instruments. The answer? Probably, and while fees will be in the cellar, so will return dispersion.

Such a scenario is a long way off, however, according to BlackRock’s Kate Bernhardt during a panel on passive investing as part of Bloomberg’s inaugural Buy-Side Week 2017 New York event. “Of the $26 trillion U.S. equity market, the proportion of single stocks or single bonds held in an ETF wrapper last year was around 7%. For mutual funds, that number is 36%.  For the $48 trillion bond market, the comparable figure is less than 1%. It’s pennies on the dollar. If you’re characterizing the trends in flows today as all active into passive, you’re missing a lot of the nuances.”
 

 

Another structural topic increasingly debated is the fear that ETFs will have a negative effect on liquidity. But that’s a very 2011/12 way of viewing it, noted Krishna Memani, Chief Investment Officer at OppenheimerFunds.

“If you are a bond manager, you know liquidity has always been suspect. Like-minded movers can dominate the market, and outside players don’t take the other side in a particular issue. But when you aggregate it all and provide a separate vehicle, speculators can come in and take the other side of a trade. ETFs have categorically added liquidity to markets, not the other way around.”

“Structurally, the majority of ETF assets are in ‘40 Act funds, which means they are essentially mutual funds with two exceptions: they can trade with each other, and they provide intraday NAV’s instead of end-of-day ones,” added Jim Rowley, Senior Investment Strategist at Vanguard. Both provide levels of trading that would otherwise not be possible.

However, consider that ETFs accounted for approximately 30% of U.S. trading by value and 23% by volume last year, seven out of the top ten issues by volume in 2016 were ETFs, and overall ETF trading volume grew 17% last year after jumping a whopping 50% in 2015, according to Credit Suisse. By comparison, U.S. stock trading volume has grown an anemic 7% since 2014.

The concern is that the high proportion of ETF volume masks an inherent liquidity trap when it comes to the underlying assets such funds represent. It’s not the volume of ETF trading itself that matters, but how that volume is ultimately translated to each index’s constituents – especially if everyone heads to the exits at the same time.

Finally, an element often missing from the active versus passive debate is what happens to corporate governance as passive market share grows. When index funds and ETFs own most of a company’s stock, does management still have its feet to the fire? Vanguard’s Rowley pointed to his company’s active governance team and others like it as a reassurance, but OppenheimerFunds’s Memani isn’t so sure. “The markets are much better vehicles for enforcing such discipline,” he said. In other words, a few emails to management from a passive fund’s governance desk is not going to replace Bill Ackman or Carl Icahn showing up at a company’s annual meeting with a shareholder value plan and slate of director nominees. “For this reason, I don’t think the trend towards indexing gets to 70-80%,” Memani added. “We need intermediaries in the marketplace.”

Finally, delving into the active versus passive debate also raises the question of whether at least a portion of today’s indices are merely replicating what used to be an active approach. “Screening for fundamentals and using quantitative, tech-based tools to build a portfolio is what active managers have been doing behind the scenes for years, whether in a separately managed account, a mutual fund, what have you,” noted Bernhardt. “A rules-based index that screens for specific fundamental criteria, for instance, and is then accessed through a cost-efficient, tax-advantaged, transparent vehicle like an ETF is redefining active, not replacing it.”

The growing role of ESG investing in portfolio management

Early performance indicators and the data horizon

Sustainable investing is gaining momentum among financial market participants. To meet rising investor demand, more asset managers are incorporating “environmental, social and governance” considerations into their investing strategies and an increasing amount of research suggests that their approach aligns with positive financial returns. With a myriad of factors to consider, how can asset managers make sense of the current market landscape to more effectively incorporate ESG information into their investment strategies?

According to the Global Sustainable Investment Alliance’s 2016 Global Sustainable Investment Review, sustainable, responsible and impact investment assets – which by definition include ESG considerations – reached nearly $23 trillion last year, a 25% increase from 2014. About $9 trillion of those assets were in the U.S. Bloomberg’s 2016 Impact Report found that “1 out of every 5 dollars under professional management in the U.S. is managed using sustainable and responsible investment strategies.”

At the same time, market dynamics are evolving, Brett Schechterman, global head of fixed income platform solutions at UBS Asset Management noted during a panel at Bloomberg event on the current fixed income landscape in May. “It’s now, I think, a bit of a mix between people (investors) who want access to ESG factors in a passive or smart beta context versus people who are looking to active managers to incorporate ESG components into their investment processes as part of portfolio construction.”

Asset managers are reaching an “inflection point,” where they are now blending their own credit research with standard input from market data and research providers. The resulting output can include proprietary scores and historical ESG industry and company performance data. “They’re trying to tilt accordingly to standard indices and trying to differentiate (by generating alpha) that way,” Schechterman said.

Venky Venkataramani, CFA, Global Head of Fixed Income Beta Solutions at State Street Global Advisors, mentioned that his firm is seeing interest from clients for ESG factors in their portfolios and that more tailored indices would be helpful in meeting their overall investment objectives. Weighted properly, indices that incorporate ESG factors will allow them to keep track of their progress on both the social and investment fronts.
 

 

Another dynamic  to watch is the divergence between government agencies and investors when it comes to the priority of ESG factors. Despite recent announcements from Washington about intentions to roll back environmental protections and re-emphasize the use of a coal, for example, Schechterman expects investors to continue pressuring companies to address their concerns – regardless of government action.

“I think the investor base is going to be stickier to see how those long-term outcomes play out,” Schechterman said.  Venkataramani added, “This investor base will ultimately demand similar (or better) return outcomes from ESG strategies.”

In the securities market, some studies report that positive ESG tilts are often evident in solidly performing funds. Russell Investments studied the issue in 2015, finding that many active managers looking to increase value over their benchmarks have seen positive ESG tilts. In multiple geographies, the number of active managers with positive ESG tilts outpaces the number with negative ESG tilts. Although the reasons are unclear, considering ESG during portfolio construction often results in stronger performance. According to the CFA Institute, it may have to do with how ESG Key Performance Indicators are often effective evaluators of both single-investment risks and overall portfolio risks.

Research from Barclays on the impact of ESG on the performance of US investment-grade bonds, found that portfolios that maximized ESG scores outperformed the index. One reason for the outperformance?  According to their report Sustainable investing and bond returns, they addressed the impact of a company’s low ESG score on associated subsequent credit rating downgrades and overall negative returns.  After testing this theory, they were able to show that “bonds with low governance scores experienced a consistently higher rate of subsequent downgrades than those with high scores. 

Does this imply that ESG considerations could be a valuable measure of risk? As more investors seek to align their portfolios to include investments that have a positive impact, many are looking beyond traditional financial and accounting data.
 

 

ESG data has the ability to expose potential risks that could negatively impact a company or industry in the future, such as any practices that may spawn regulatory action or large operational or business changes.  Research in the Barclays’ study found that more investors are becoming “prudent to avoid investing in companies that have a detrimental impact on the world.”

Yet, investors and portfolio managers remain concerned with the inconsistency and lack of data they need to effectively incorporate ESG information into their investment strategies.  The Bloomberg Impact Report cites a PwC study that found only 29% of investors are confident in the information they are receiving.

Groups such as the Sustainability Accounting Standards Board and The FSB Task Force on Climate-related Financial Disclosures are aiming to align many of the ESG reporting frameworks to bring consistent and transparent standards to investors, issuers and the market.

This development will be critical for asset managers to align their portfolios to meet the altruistic needs of a growing number of their investors, while still maintaining financial performance.