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Abu Dhabi, UAEMonday 10 December 2018

Why the active money manager model is no longer viable

The investment method is being disrupted by low-cost passive options

<p>Companies, such as Vanguard, offer investors a&nbsp;cheaper passive/exchange-traded fund model. Kristoffer Tripplaar / Alamy Stock Photo</p>
Companies, such as Vanguard, offer investors a cheaper passive/exchange-traded fund model. Kristoffer Tripplaar / Alamy Stock Photo

A few years ago, investment blogger Michael Batnick posted a timeline of the great money managers since 1870. What was striking about the list of 67 was that only five were born after 1960: David Einhorn, Ken Griffin, Cliff Asness, Bill Ackman and Dan Loeb.

So why are no star investors under 50? The simple answer is that the financial crisis took a serious toll on the industry. Active managers have underperformed benchmarks for far too long in one of the greatest bull markets in history. As a result, they are losing assets to firms focused on low-cost, passive investing strategies, a shift that is shaking up markets in a not necessarily good way.

Today, the best and the brightest students are avoiding financial services in favour of more lucrative jobs in technology. A 2013 graphic from the Harvard Crimson shows that only about 5 per cent of MBA graduates entered investment banking, compared with almost 20 per cent going into technology. Back in 2006, it was about 12 per cent for investment banking and 7 per cent for technology.

Active management is being disrupted, and passive options are the disruptors. As was the case with taxi drivers fighting Uber, these disruptors are not going away. Higher volatility may help some active managers, but investors will need to see long periods of outperformance before reconsidering their affinity for passive investments.

The chart below shows flows into passive ETFs (red) and active mutual funds (blue). Highlighted on the chart is the depth of the financial crisis, September 2008. This appears to be the inflection point where investors soured on active management in favour of passive investing. So, if one thinks a bear market or more volatility will save active managers, the last bout certainly didn't.

<p>Graphic by Roy Cooper</p>
Graphic by Roy Cooper

The game plan for active managers has always been about maximising assets under management. More assets equated to bigger paydays for managers. But, as the charts attest, the current active management model cannot compete with the cheaper passive/exchange-traded fund model in asset gathering or in terms of returns.

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Read more:

Vanguard takes its $5 trillion low-cost revolution to China

Finance guru Andrew Hallam’s new guide for expats wanting to become wealthy

Has the good fortune for ETFs run its course?

The return of active has been helped by the pitfalls of passive

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So why should you care? Capitalism is supposed to reward good ideas and punish bad ones. This helps the economy evolve rather than stagnate. Passive investing may have provided superior returns in recent years, but it does not properly allocate capital.

What does the future of active management look like? We believe it should only seek a portion of an investor’s assets. To do this, they will have to create highly idiosyncratic and concentrated portfolios. They will have to find the one thing they do well and do it in a concentrated, risk-seeking way, whether it be health-care, emerging markets, macro themes, algorithms, technology or trading. The manager will need to be known as the “go to” person in that space to emerge as the next star, allocating capital as efficiently as possible.

Unfortunately, many active managers take the exact opposite approach. They focus on gathering assets via a diversified, broad based, index-hugging portfolio. This model is no longer viable as passive ETFs do this more efficiently while charging lower fees. In Wall Street parlance, active managers cannot generate enough alpha to justify the higher fees over passive/ETFs.

We cannot blame recent college graduates for choosing careers outside of active management. Many difficult changes must be made in the industry and, for the time being, there are better opportunities elsewhere.

Jim Bianco is the president and founder of Bianco Research, a provider of data-driven insights into the global economy and financial markets