Study suggests different take on active vs passive

A recent Natixis Investment Managers survey of 500 global institutional investors that highlights the focus on alternative investments and ESG-related issues also unearths a different perspective on the debate of passive versus active investing.

The report notes that although a majority of institutional investors taking part in the study believe passive investments offer an advantage in managing fees, they do not always place fees above performance. Three quarters of respondents say they are willing to pay higher fees for potential outperformance. This appears to buck the trend of what is often seen as the unstoppable march of passives.

Furthermore, the institutions polled believe investors have other misconceptions about passive. Seven out of 10 say individual investors are unaware of the risks associated with passive investments, and the report offers other eye-opening statistics about the impact and rise of passives:

• 59 percent of respondents say absence of volatility is a cause for serious investor concern
• 59 percent of institutions say flows into passive strategies artificially suppress volatility
• 56 percent say passive investing distorts relative stock prices and risk-return trade-offs.

‘These are compelling points on how institutions view investing. The amount of money that has gone into passives has left some exposed,’ Dave Goodsell, executive director of the Natixis Center for Investor Insight, tells IR Magazine.  

The report also notes that 63 percent of institutional investors say the growth of passive investing has increased systemic valuation risk. ‘With markets rising on artificially low interest rates rather than the real valuations of securities, an uptick in the use of index investment has amplified the momentum, adding to institutional concerns about asset bubbles in the year ahead,’ the report’s authors write.  

Considering a potential reversal in the monetary policies that have buoyed markets, and likely interest rate increases, institutional investors project market volatility will be on the rise, as will the dispersion of returns among securities. With the interest-rate tailwind subsiding, three quarters of institutional investors say the market favors active managers.

‘What we have seen from institutions is an anticipation of rate increases,’ Goodsell says. ‘They see a potential for change in quantitative easing, not just what the [Federal Reserve] is doing in the US, but also the [European Central Bank] and elsewhere. If that starts to happen, that starts to change what has kept everything on a steady upswing.

‘Not only will they see interest rates have an impact, but they think it will have an impact on dispersions: so greater returns from different securities. They think it will break up the lock of correlation. When they see that, they say: That is a market that favors active management.’

Asked about the current allocation to active versus passive and what it will be in three years, respondents in 2015 said they would be at about 36 percent passive and viewed it going up to 43 percent. But looking at how this has developed, it has actually gone down to 32 percent in the current allocations.

Putting this into perspective, Goodsell observes: ‘In what they prefer for different portfolio functions, investors use passives strictly for fee management. For other factors, risk-adjusted returns and advantages of market movements, they are looking to active managers.’

Finding alpha in ESG
ESG analysis is also providing a greater role in institutional strategy. Among those surveyed, 44 percent say they consider ESG factors to be as important to their investment analysis as financial factors. About the same number (43 percent) say these factors are an important part of their manager selection process.

Although 56 percent agree that ESG mitigates risks – such as loss of assets due to lawsuits, social discord or environmental harm – a larger number (59 percent) believe there is alpha to be found in ESG. Their convictions about the efficacy of this approach are strong, and 61 percent of institutional investors believe incorporating ESG into investment strategy will become a standard practice within the next five years. Paradoxically, on the ESG narrative, many institutional investors still need clearer definition – institutions are split on ESG and how best to approach it.

More than a third (36 percent) limit it to the use of negative and exclusionary screening that was the hallmark of SRI strategies. Twenty-one percent see it in positive terms through impact investing. Only a small number (15 percent) see the full potential of ESG today and consider thematic investing around global themes such as climate change and technology innovation.

‘We tend to be conditioned in ESG from a negative screen – taking things out not wanted in the portfolios,’ says Goodsell. ‘But ESG can also uncover opportunities, looking thematically. There is now a real evolution of ESG that is more holistic and alpha-focused, and respondents reveal this is going to be an industry practice within the next five years. Another factor is there had been a lack of ESG measurement performance, but that is really changing dramatically with a range of rankings and tools to evaluate the impact.’

As evidence of the entrenched evolution of ESG, Goodsell focuses on another section of the report, which highlights this wider ESG commitment picture. A year ago, respondents to the survey cited their reason for deploying ESG strategies as the mandate prescribed within their organizations’ investment policy statement.

A year later, institutions now say their rationale for implementing ESG strategies is:

1. Proactively aligning investment strategy with organizational values (47 percent)

2. Minimizing headline risk (41 percent – a 21 percentage-point increase over 2016)

3. Mandated by investment policy (32 percent).

‘These are the numbers that matter the most. [ESG] really has a clear functional role in what investors are trying to do,’ says Goodsell.