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During the bear market of 2007 – 2008, many active investment managers largely underperformed their benchmarks. As a result, an existing trend towards passive investment managers accelerated. However, the trend could have been briefly interrupted as the fortunes and performance of active managers reversed in 2009. But, can it last?

Research and Insight:

As the performance of active investment managers largely lagged that of their benchmarks during 2007 and 2008, many institutional investors moved their approaches to a passive strategy, one in which an existing benchmark is replicated without any extra research or custom security selection performed by the investment manager. During the ensuing bull market of 2009, active investment managers ⁽¹⁾ tended to beat the performance benchmarks and as a result received a reprieve of sorts on outflows to passive strategies.

I believe there are a number of factors which may result in Institutional Investors continuing their move towards passive investment managers:

Rise of Outcome-based Investment Mandates – if an institutional investor, such as a pension plan, requires only a certain level of return to satisfy their obligations instead of trying to beat the market in order to close a funding gap, then it tends to be harder to justify utilizing an active manager. A passive investment approach, whereby return is provided through the market’s beta, can be utilized. A mix of equity and fixed income index strategies can easily and cheaply be structured to provide the targeted rate of return needed for a successful outcome. This enables the institutional investor the ability to avoid trying to chase alpha via managers such as Hedge Funds, except in only the smallest portion of the portfolio.

When it comes to fees, low cost passive management wins - total expenses, including management fees and costs for marketing, trading and legal and regulatory compliance, are 1.26 percent for the average actively managed mutual fund, according to Morningstar. For index mutual funds, the corresponding figure is 0.99 percent, while the average E.T.F. is run for just 0.57 percent of assets. Overtime, outperformance by active mutual fund managers becomes harder to achieve, given the overhead of fees.

Trend towards ETFs - each month, more ETFs are launched. This provides Institutional Investors yet another means of structuring a portfolio of  low cost vehicles.

Focus on Absolute Return instead of Relative Return - investment managers have always marketed their performance based on how they did “relative” to the benchmarks. With the market turmoil of the last few years, institutional investors turned their attention to portfolio risk and how returns were generated relative to the return provided. As a result, clients are focused on the absolute return provided by an investment manager. Combine the focus on risk-vs-return and outcome-based investment mandates, and it appears that institutional investors will be more likely to favor a passive investment manager who seeks to replicate the absolute return provided simply by mirroring an index.

In conclusion, by examining some of the factors that play into the recent trend towards passive managers, it enables us to understand the big picture behind institutional AUM inflows and outflows. Data released by eVestment Alliance and Casey Quirk and Associates, who studied global assets and flows, breaks down investment strategies into four risk categories: index, structured, active and aggressive.

• Passive funds were the only strategy that saw positive inflows over the one-year period ending September 30, 2009. Passive index strategies took in $109bn.
• Structured funds, considered a less risky asset class, had $54bn in outflows.
• Active funds suffered large outflows. Active strategies suffered $111bn in net outflows.
• Aggressive products lost $149bn to outflows.

Active managers are going to have to find means of differentiated products, services and strong performance if they hope to postpone the trend towards towards passive investment managers by institutional investors.

⁽¹⁾ Note: For the purposes of this article, we consider active investment managers those who make investment decisions based on market-timing or research driven security-selection processes.