The End of an Era & The Rise of Active Management for Cryptocurrencies
When Vanguard Group founder Jack Bogle created the world’s first index mutual fund for individual investors at the end of 1975, he launched an era of low-cost investing and started a movement that would come to define the next four decades.
The value proposition of index investing is simple. In the long run, index investors such as Bogle argue that it is difficult, if not impossible, to consistently beat the market, so why even try? Instead, Bogle ushered in an era of passive investing, which invests strictly in indexes. Forget about picking stocks, save on the fees and simply fasten your seat belt and ride the roller coaster that is the market.
But what started as a fringe idea may now have become mainstream. According to analysts at Morningstar, sometime this year, assets in passively managed U.S. equity funds are likely to surpass assets in actively managed ones.
In the same way the past decade has been rough on hedge funds, the epitome of active management, passive, low-cost investing has been having its day in the spotlight.
Doing Less By Doing More
But the passive investing strategy pioneered by the recently deceased Bogle may now be a victim of its own success, with many ostensibly passive index funds appearing to be more and more “active” in other areas as investors increasingly demand more.
One of these “active-passive” investing strategies is known as “smart beta.” As passive investing has grown in popularity, many investors are no longer content to just “ride out” market cycles, introducing greater managerial discretion, not in picking specific equities, but in everything else — from sector and asset selection to geographic region focus.
Smart beta funds are another way investors are becoming less passive while still taking advantage of the cost savings and automatic nature of index investing.
Instead of holding shares of companies in proportion to their market value, a smart beta fund may hold them in proportion to some other measure such as sales, dividends or book value, with the goal of beating the market.
For instance, a smart beta value fund may try to beat the market by a greater proportion of stocks with a low price in relation to book value — something that only value stockpickers such as value investors Warren Buffett used to do.
And thanks to the transparency within the markets, the explosion of copycat investing strategies has gradually eroded any alpha that active-passive strategies had sought to achieve, with strategies replicating various hedge funds as well as those that suppress volatility all vying for investment dollars.
The End of an Era
And perhaps nowhere has transparency of the market demonstrated how much the playing feel has been leveled than in Bill Gross’s retirement.
A legend in his time, Gross co-founded the bond investing behemoth Pacific Investment Management Company, better known as PIMCO, in 1971. After a conventional career in finance and risk, plus a brief foray to Las Vegas as a professional blackjack player, for decades, Gross demonstrated extraordinary acumen not just in evaluating securities, but also knowing when to “hold ’em, when to fold up, when to walk away and when to run.” Thank you Kenny Rogers.
Gross displayed an almost superhuman ability to known when to push maturities just that little bit longer or shorter than the average so that he could beat the market. And his calls (which were more often than not right), were often public and amplified by his regular appearances as a talking head on a slew of television programs, providing punchy soundbites and entertaining viewing on otherwise staid fixed income segments on Bloomberg, CNBC, Fox Business and MSNBC.
Gross’s approach was in stark contrast to the other fixed-income managers of the time who were content to lock themselves up in their ivory towers and his work paid off in spades.
The combination of Gross’s talent and publicity attracted a flood of money, with PIMCO reaching a peak of US$293 billion under management in 2013.
But an internal shake-up in 2014 saw Gross leave the company he helped co-found, to join a mid-sized fund, Janus Henderson.
And while some of Gross’s clients followed him to his next gig, Gross had lost his magic. Performance (especially in the face of substantial fees) was lackluster at best and a steady flow of redemptions followed Gross to Janus Henderson. Today, over half of the US$950 million managed by Janus Henderson is Gross’s own capital.
But Gross may not have lost his mojo as much as he may have been a victim of his own success. Today, it is easier than ever before to study and mimic trading strategies. And the nature of the debt markets has also changed over the decades, making many of the informational asymmetries that Gross often leveraged, no longer available. After almost four decades, Gross, the once dubbed “bond king” has finally hung up his hat and announced his retirement.
In a televised interview, Gross said that he had continued to outperform in the management of some funds outside his original sphere of excellence (fixed income), which perhaps says a lot about where active management can still be effective — in niches.
Gross may also be the last shoe to fall. His retirement, hot on the heels of the passing of Bogle who defined passive investing, underlines just how much money-management has changed during the two titans storied careers.
With increasing transparency, machine learning and artificial intelligence, the heady days of 30% to 40% returns from market managers, chasing ever more elusive alpha may be harder to find in the future.
Success in Niches
Which is why alternative assets such as cryptocurrencies may have an advantage for the astute investment manager and the tenacious investor.
Being small (total market cap of all cryptocurrencies exceeds US$120 billion on a good day), it doesn’t take much to move the market. And because information doesn’t travel efficiently or transparently in the cryptosphere, astute managers are able to generate alpha at levels unheard of in capital markets.
Add to the inherent inefficiencies in the cryptocurrency markets, the complexity and informational asymmetry and it’s not difficult to see why cryptocurrencies have what one manager refers to as a “knowledge premium.”
Call it “smart alpha” if you will, but even pedestrian strategies drawn from the capital markets and applied to the cryptocurrency markets — stuff that you’d be learning in a basic finance or trading course at any Ivy League school — can yield outsize returns.
And because there is informational asymmetry, passive investment strategies — cryptocurrency ETFs (where available) and cryptocurrency indexes are nowhere as effective as actively managed strategies.
A quick study of the number of long-only or unidirectional-biased cryptocurrency funds that were all the rage in 2017 has demonstrated the paucity of a one-way bet on cryptocurrencies.
To that end, the cryptocurrency markets have reached that stage of requiring more in-depth active management earlier than perhaps the capital markets ever did. Where before, any initial coin offering (ICO) could “moon” and make you an instant millionaire, today, trading for alpha in the cryptosphere is to literally swim in a very shallow and very murky pond.
And while there may yet come a time when ETF investing in cryptocurrencies is a sign of good husbandry, if the traditional markets are any guide, active management in cryptocurrency markets are likely to outperform more passive methods in the medium to long term.