Active investing, certainly not free from disruption

This is just a short introductory post, but it will be one of many on this topic. In my industry (investment management) there is a lot of change taking place, particularly in relation to the type of products investors are buying. For those in finance, you will no doubt be aware of the ‘active vs. passive’ debate. For those less familiar, stick with me, because in a series of blogs, I will uncover all you need to know.

To be clear, my opinions are not intended to be bias towards either approach, I strongly support both active and passive, but I feel we (on the active side) are neglecting the underlying reasons why passive investing is becoming increasingly popular, especially with the Millennial generation.

A bit of background — Active vs. Passive

Let’s firstly take it back to basics, historically, investors who wanted to profit from the the stock market either went to a financial adviser, who would then invest on behalf of their client, or they invested in the stock market themselves. But to add a level of complication to this, individuals and financial advisers could also give their money to a mutual fund, who then invested it in the stock market. The below diagram hopefully simplifies this.

If you are wondering why anyone would give their money to an intermediary (like a mutual fund or adviser), then it is simply because one believes their expertise, in generating you wealth, is worth paying for. In other words, they are considered ‘experts’ at investing, because of this, they are less likely to lose you money than if you did it yourself. This, of course, is debatable.

Cost, cost cost…

But where this traditional method is falling down is on cost. As with anything in life, every layer of service carries a cost. In other words, using a financial adviser and/or a mutual fund is expensive and this cost is passed to the individual investor. This may not be a problem for those Baby Boomers, who are not used to those endless late night Google searches just to try and get a better deal on their new TV, or rigorously searching for that 10% coupon code to use on ASOS. But as a Millennial, I am struggling to see how this traditional business model can survive in a world where value for money is ingrained within the mentality of of younger generations. Particularly now that passive funds offer a similar product at a fraction of the cost.

I do not want to come across as overly critical of active management, because I am a supporter of it. However, we can’t ignore the fact that there’s a new kid in town and this kid uses a fidget spinner, while all the other kids are still chasing a hoop down the road with a stick.

This new kid is, of course, the wide array of low cost passive products. I will cover what they are in a separate piece, but for now, think of them as mutual funds without an expensive investment team. Because they don’t need expensive investment teams (they use computers), the charges are much much lower. This diagram hopefully simplifies the difference.

Briefly on charges, active funds typically charge between 1–2% each year (there are sometimes additional charges on top of this, another discussion), passive funds can be as low as 0.1%. This may not seem like much but when you compound this over a 30 year period, as the below chart by Vanguard shows, this can make a huge £12,000 difference.

But… Do you get what you pay for?

The question most commonly asked is whether active funds outperform passive funds, thus justifying the higher fees. I am not a particular fan of this question because it is far too general. It’s a bit like asking who is better at sport, a football player or a hockey player? It is far too general. That said, many active managers fail to beat their benchmarks consistently and this increasingly poor reputation brings down the whole group.

Let’s be frank, the hunting ground for active managers has long been the Baby Boomers and rightly so, they are the wealthiest generation ever. However, by doing this, they have neglected the Millennials. It is therefore unsurprising to see that Millennials now account for a considerable chuck of passive products, far more than their Baby Boom counterparts.

Now back to my original point on why the active strategy of charging higher fees needs to adapt quickly so it appeals to younger generations. Imagine you are at a party and the host is pouring Champagne into a glass that is stacked on many other glasses. The first glass fills and begins to trickle down into the second glass and this fills up the third glass and so on, in much the same way as wealth passing down through generations. The top glass will be drunk first, leaving it empty and the remaining Champagne from the bottle will be in the second and third glass, in other words, the younger generations. Thus, sticking to a strategy solely targeted at the Baby Boomers is at the expense of price-sensitive Millennials.

Additionally, since the financial crisis, trust towards financial institutions, who are commonly seen to be making too much money, has fallen dramatically. Trust takes a long time to build back up, and for as long as the active management industry is being criticised for high charges and poor performance, this reputation will not improve, meaning that younger generations, as they become wealthier, will be less likely to park their savings in an active product.

The reality is, many active managers offer great products, however, most are ignoring the real threat of passive investing and this is unwise. The old industry must learn to accept the rise of this popular type of investing and adapt strategies to best wether the inevitable creative destruction that is forming quickly around them.

JR’s Open View