The debate of whether passive investing trumps active investing rumbles on, but the world in which it is waged changes. In an unspectacular market, savings on fees with cheaper passive mandates can make a difference to pension funds' bottom lines. But in today's volatile world, Pension Funds Insider asks if passive investing gives funds too much exposure to possible future financial fault lines

Naturally, it is active managers are most likely to be heard making noises about the need to steer clear of new forms of systemic risk. Bernard Abrahamsen, head of institutional sales at bond managers M&G, says that in the current environment "you really have to mind your eyes as to what you're exposed to. If I were a trustee I wouldn't want to be a hostage to fortune by blindly gaining exposure to the market".

Abrahamsen suggests that passive corporate bond trackers, for instance, instinctively pick up bank bonds and go heavy on companies with large debts, tying the funds who hold them into greater systemic risk which may be undetectable in return figures until the worst case scenario of another banking crisis should happen.

"From a risk-return view you really have to take active decisions" Abrahamsen says, "as an investor you might think its fine that we are in a regulated environment and you are holding investment grade public bonds on which the investment banks have done due diligence, but surely the language contained therein has some kind of bearing on the risk you are running and whether you should be compensated for holding that security".

In further advocating active he says that "as we have been living beyond our means and there is a lot of debt outstanding that will cause restructuring in the next few years, a high level of selectivity is not a bad thing. There are plenty of opportunities, there's no need for gloom and doom, and if you know what you're doing this kind of volatility and uncertainty can really make a difference."

Several investment experts are saying that range of current market uncertainties make managing risk and volatility especially important. A recent Baring Asset Management survey, for instance, found that the Eurozone debt crisis was viewed as the single most pressing risk to investment growth over the next six months.

Peter Elston, Aberdeen's Singapore-based strategist agrees too that in the equity market "there are risks right now that can be avoided with a simple bit of research and common sense. The indiscriminate and arbitrary nature of passive investing can't do that".

Although he emphasises that the extremely complex nature of systemic investment risk means avoiding it "is not something we rely on to outperform", Aberdeen's funds will take a clear position on certain wider risks. For instance, an investor buying into their Asian equities fund will have much less exposure to exporters who are dependent European demand than a typical Asian equity ETF investor.

There are no signs of a major movement away from passive to active amongst pension funds, although there are examples that the current risk environment is deterring those less familiar with passive investing instruments. In Switzerland, for instance, Mario Passerini, head of the €1.03bn Schindler pension fund recently admitted to trustees having abandoned the fund's first passive mandate in 2010 on concerns for the levels of Irish and Greek debt that it was unwittingly being exposed to.

Fair deal

If active managers really want to woo pension funds away from their passive counterparts, they will have to make a case that their subjective analysis produces the kind of performance that justifies their higher fees. This remains a lot harder to establish than a criticism of the risks that passive investment may bring.

This month, the latest of a long line of studies was released emphasising the poor value of active investing. A pair of Uppsala University academics found that only two out of a sample of 36 Swedish active investment funds regularly outperformed their benchmark over the 15 years between 1995 and 2010.

For all the promises on avoiding unpleasant exposure to certain risks, why would a pension fund want to increase its active holdings when the performance statistics are so poor?

Abrahamsen argues that pessimism at poor market growth prospects means schemes should be prepared to look beyond benchmark-chasing mandates, saying "the priority of a passive manager is matching market performance. But the question is; is market performance good enough in the current environment? As a pension fund market performance does also not in any sense mean that your liabilities will be matched."

In explaining why the extra expense of active management is generally not reflected in performance, at times the active industry turns in on itself. Elston says "our enemies are the 'benchmark huggers' who claim to be active and charge active fees but are quasi-passive. The response of too many active providers to the rise of passive has been defensive, building funds to focus on following an index, but these managers will never produce good performance once their active fees are counted".

Elston adds that he feels "fees should be considered only with the extent to which a fund is actively managed, but it's very hard to get that message across."

This point has been supported by a group of four leading financial academics, who recently produced an analysis of actively managed mutual funds in 30 countries based on their 'active share' – revealing how active they really are. 

The study concluded that "the most actively managed funds charge higher fees but outperform their benchmarks after expenses", but "in many countries, investors are not given the option of paying lower fees for explicit passive management, but instead they pay higher fees and receive implicit passive management rather than receiving the benefits (and higher returns) from truly active management."

Martijn Cremers of the Yale School of Management, who headed the study, told Pension Funds Insider that he definitely sees opportunities for active managers in the current investing environment, saying that "managers are more active if there are better opportunities, including more volatility and liquidity. Sovereign debt and geopolitical risks will increase volatility but may potentially decrease liquidity in some, for instance emerging, markets."

Steve Leach, a spokesperson for Legal and General says, on the contrary, that the price advantages of passive investing make the approach particularly attractive in times of market uncertainty, saying "as returns from equity come under strain and you are expecting just single digit returns, you want to make sure that the management fees are minimal. At these times active funds will generally just offer the same market exposure in a much more expensive way."

After all, says Leach, funds still have the popular option of using passive funds as a core market exposure with active mandates forming a satellite alpha option.

"A passive fund will do as it says on the tin by giving the precise exposure that it claims in the cheapest and most efficient way, and if that is what the purchaser wants there is no scope for misunderstanding. It is for funds to decide whatever level of market exposure and risk they want," adds Leach.

Leach asserts that "active and passive are different approaches and serve complimentary purposes."
With passive providers like L&G continually adding to their pensions business (L&G now manages some £228bn on behalf of UK pension funds) a recent Hymans Robertson survey reports that at least 40% of UK pension assets were managed passively at the end of 2010. Some active managers suffered significant annual drops in assets under management, the research claimed, with Aberdeen losing 16% of its pension assets in 2010 and AllianceBernstein suffering a 25% drop, due to performance problems. 

It seems many trustees still view their best bet in reducing unwanted risk lies in a passive provider.

First published: 19.05.2011

dbillingham@wilmington.co.uk