Seven Trends in Active Investment Management: Ronald N.Kahn
Introduction
Ronald N. Kahn’s book, The Future of Investment Management explores the key trends within investment management (IM) and is particularly significant as these trends help forecast the future of IM over the next 5-10 years. Khan isolates two trends – smart beta and big data. ‘Smart beta is a disruption’ and ‘big data is the opportunity for active management’. Khan predicts that IM will evolve into three distinct branches: indexing, smart beta, and pure alpha. These branches could offer return focused and sustainable products, which important to keep in mind for the creation of new investment strategies. Diving deeper into the trends helps aid the understanding how these distinct branches have been created:
Trend 1. Active to Passive
There has been a large shift from active to passive investing. Why? The argument against active management is extensive and supported by a wide variety of data. Despite behavioural finance and excess volatility suggesting how active management has the potential to outperform, this outperformance is prone to be temporary. Active managers can identify inefficiencies that the market has not yet understood and can trade on them, however this strategy only works until the market figures them out. Khan describes them as, ‘narrow and transient sources of return’. Therefore, over an extended period, active managers need to consistently find informational inefficiencies.
However, with the rise in passive investing, a recent academic study by UCLA suggested that passive investing has increased market volatility and reduced market efficiency. For the foreseeable future, this is not a significant problem as passive investing accounts for approximately 30% of the US stock market – a side note to think about!
Trend 2. Increased Competition among Active Investors
With increased competition amongst active investors, fewer secret market inefficiencies are present, hence active mangers have difficulty outperforming. Kahn said, ‘as more people understand these market inefficiencies and trade on them, they disappear’. This relates to the concept of academic research destroying stock market predictability, which is further explored in a paper by R.David McLean and Jeffrey Pontiff – would highly recommend! One question to also consider is whether active management can become even more competitive than it is today? It is expected to remain highly competitive, but how competitive?
Trend 3. Changing Market Environments
Investors need to adapt to the changing trading environment. The emergence of high frequency trading is apparent in Figure 1. The average trade size has decreased significantly from approximately 1,00 shares per trade to 200 shares per trade, suggesting traders are splitting up larger trades into smaller trades.
The shifting landscape is both good and bad news for active managers. Kahn observed that as an ‘investment moves from active to index… the other side of the trade is likely to be an index fund’. Therefore, active investors will compete against uninformed indexes. Hence the obstacles lie with institutional investors, who hold larger positions.
Trend 4. Big Data
Big data takes a vast array of forms – text, social media, images, search data are mere examples. With the data revolution, accelerated by the internet, anyone can access the data used by the professional investors. Additionally, big data provides investors with insights to alpha generating market inefficiencies! Kahn states, ‘this explosion of available data is the greatest new opportunity for active management in many years.’
Trend 5. Smart Beta
Active investing may be very disruptive for smart beta. What percentage of active returns are smart beta? Kahn explain, ‘On average, the factors explain 35% of active returns’. If investment managers are delivering smart beta returns, charging active fees should not be occurring. Therefore, is there still an opportunity for pure alpha? Investors seek all the returns they can get, whether they are pension funds or endowments. However, pure alpha can be gained from active managers, therefore this is a key focal point for active managers moving forward.
Trend 6. Investing Beyond Returns
Environmental, social, and governance (ESG) investing has produced a growing amount of interest globally. Analysing any observed trend, it is important to look at what causes the trend and why the trend should continue. For ESG investing, the following points reason:
· Demographic shifts; more control of wealth to women and millennials, two groups with increased levels of interest in sustainability
· Higher levels of understanding of risks associated with climate change
· Government regulations increasing company disclosures, requiring investment managers to take sustainability into account
An opportunity arises for active management where ESG and big data overlap; ESG scores commonly reflect companies’ policies rather than actual practices, therefore measuring company performance can get complicated. Investors who seek a more subtle ESG, without being exclusionary may be after an opportunity for active management. With ESG investing potentially intensifying in the next 5-10 years, this is a vital opportunity for active management.
Trend 7. Fee Compression
Fees have been compressed, and the two previous trends – active to passive and smart beta – exemplify that investment flows are currently moving from high-priced products to lower-priced products. Will fees continue to fall? Kahn predicts further decline in active fixed income.
Therefore, active management continues to evolve into indexing, smart beta, and pure alpha branches.
Additional Information
The Future of Investment Management - CFA Institute - Access Here