Recently, as part of a panel of asset managers and financial journalists discussing the future of our industry, I was asked to highlight two of my fears.
My first was a fear for democracy and the important role the media plays between politicians and those they govern. One of the roles of a free press is to challenge politicians. If such a role was to disappear, if journalists were to no longer be adequately compensated, who would provide this valuable public service? Yet the public is increasingly unwilling to pay for news services.
My second fear concerns markets and the economy. What will happen if the current trend towards passive management continues? What will happen if investors are more and more reluctant to pay for active management?
There is a commonly held, but deeply misguided perception that active managers typically do not represent “value for the money” because they cannot beat a cap-weighted market benchmark.
This belief that active managers do not represent value stems from misguided arguments by passive managers. Such index-investing pioneers have been known to call active management “a loser’s game” arguing that investors should favor passive investment. This argument actually confuses the role played by investment benchmarks.
Active managers typically cannot outperform their designated benchmark because the benchmark is determined by the sum of activity performed by active and passive managers combined. And because passive managers have no impact on the benchmark – they merely follow it – it is, in fact, the sum of all moves made by active managers that actually determines the benchmark.
Similar to the journalists, the reluctance to pay for skills, research, hard work and added value has significantly increased in a world where the feeling of free and easily accessible information has led to the idea that we no longer need to pay for quality services.
It is vitally important that investors understand that benchmarks are an output of the investment management process and should be used as little as possible as input. As we have seen, confusing this point is dangerous for their own performance and for the economy as a whole. Yes, the average active manager often cannot beat a cap-weighted benchmark, but that does not mean as a group they are useless – far from it.
In this context, a long-term investors’ decision to opt for passive management means that a critical pool of capital is effectively resigning its role in value creation and/or growth generation. It is the role of investment managers to ensure wealth generation for those whose funds they are allocating. The main group behind wealth creation is long-term investors allocating to active managers. They should not simply resign these responsibilities. Neither governments nor central banks can succeed in this role.
The benchmark is the output of all activities performed by active managers. It is exactly equal to the sum of all non-passive portfolios. To assume the market cap-weighted benchmark is an input to the investment process is a dangerous mistake. The role of active managers as a group is to drive the benchmark upwards by allocating capital to companies that add value to the economy. If capital is allocated to companies that destroy value the benchmark will fall.
Long-term active managers should recognize that their role is not to beat a benchmark that they themselves effectively run when in actuality they help to run something much more vital – the economy itself by allocating capital towards value creation. One of the most important jobs for which active managers are paid is an externality: running the benchmark! If they were to no longer be adequately compensated who will pay for this valuable service?
When fewer fees are allocated to active management, the less skill we will attract to running the benchmark and indirectly running capital and the economy towards value creation. What would the economy and market look like in the absence of active management decisions – a dog following its tail?
Managers will continue to be systematically challenged. Their skills, research capabilities, dedication and of course results will be regularly available for examination and debate.
Capitalism cannot exist without efficient and active capital allocation.
This makes it a price worth paying.
Yves Choueifaty is founder and CEO of TOBAM, an independent, employee-owned asset-management firm based in Paris (www.tobam.fr). He is the former CEO of Crédit Lyonnais Asset Management.
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