The (Renewed) Case for Active Investing

Additional Contributors: Robertas Stancikas, Harjaspreet Mand and Maureen Hughes

Executive Summary

• A new investment regime will prompt a rethinking of the role of active management in investing, as a return of the business cycle and less trended markets dents part of the case for simply holding passive long positions in public markets.
• Asset owners face lower long-term real, or inflation-adjusted, returns in the years ahead. The response should be to allocate to a combination of different risk types, including illiquid assets, factor strategies and active strategies.
• As we see it, the true goal should be maximizing net-of-fee returns. While alternatives will continue to take the lion’s share of fees, we advocate a more holistic approach to deploying fee budgets, targeting areas where managers can deliver idiosyncratic alpha across public and private markets.
• As environmental, social and governance (ESG) investing continues to evolve, it will lead investors to articulate a clearer picture of what it really means to be active and passive when it comes to ESG investing strategies.
• Passive proponents claim that market-cap-weighted indices should be a starting point, but when it comes to China, we suggest that the “proper” weight is highly unclear. Changes in that weight could prompt disagreements among investors, raising questions of what it means to be passive.
• We think strategically higher inflation will prompt a rethinking of benchmarks, with more investors identifying inflation as the true benchmark, not a financial market index. Seen in this light, there is in fact no such thing as being truly passive.
• We’re not intending to defend all active investment in a blanket way. However, the current regime change will prompt asset owners to set limits on how much of their asset allocations can be directed to passive strategies.

The Road to a Renewed Active-Passive Discussion

There was a lot of excitement in active-management circles during the COVID-19 pandemic, as the share of equity assets run passively dipped—the first discernible pause in its inexorable upward trajectory in more than a dozen years. However, flows into passive from active have accelerated once again (Display 1), with passive now accounting for 48% of global assets under management (AUM); for US equities, the passive share is 52%.

Does the resumption of this long-term trend mark the path forward for asset owners? We don’t think so. The active-passive debate cannot be divorced from the broader macro outlook for global capital markets, and that outlook delineates a different future.

The active-to-passive rotation has unquestionably helped lower investors’ fees over the past decade, but the persistent nature of the rotation prompts a question: Is there a limit to the degree that equities can be managed passively?

Six years ago, we made the case that passive-management growth affects efficient capital allocation. Seen through the lens of efficient economic allocation of capital (as distinct from an investment perspective), we’ve argued that passive investing is worse than Marxism.¹

At least in a Marxist economy, someone is planning where capital should go. The painful reality for those believing in the broader economic benefits of active management is that the market has no intrinsic feedback mechanism to correct this.

How would one even know in “real time” if capital allocation in the economy had gone awry? If it took years to notice a misallocation, it would be hard to envision a way that this could be self-corrected. What’s more, we’re not aware that anyone has been able to articulate exactly where a limit might exist beyond which capital allocation would break down—or even if the relationship between the active-passive split and capital-allocation efficiency is linear or nonlinear.

Others have suggested potential limits to passive investing based on market efficiency. Perhaps too much passive investing would somehow herald an active-management nirvana? Well, Japanese equities are close to 80% passively managed, and yet there’s no sign of sustained supernormal profits generated by active managers. Still others have suggested limits in terms of market function; therefore, an implicit potential limit on passive investing from a regulatory perspective.²

Our own research has noted that markets with a higher penetration of passive investing tend to endure correlation spikes of a higher amplitude when exogenous shocks occur. Maybe that link is enough to pique regulators’ interest, though correlations tend to revert to the mean. The view that passive investing leads to a sustained rise in correlation was surely shattered by the great declines in correlation in 2016–2018 and 2020–2021.

All of these views describe theoretical limits to how much money can be run passively, but we don’t think any of them translate into a practical limit. Regulators and politicians should care about efficient capital allocation in the economy, but it’s too nebulous and slow-moving a topic to demand action, and it’s lowering investors’ costs. We think the limit to passive investing’s penetration will come not from the market itself but from asset owners.

Asset Owners Set the Limits for Passive Investing

We think the passive share of equity and fixed-income AUM will continue to rise—it would take a brave analyst to call a turning point in a series so monotonic. One could no more declare a turning point in that series than King Canute could command the tide to recede.

Asset owners will come to realize that the infatuation with passive investing doesn’t work when the macro regime has changed. Recognizing this new regime, combined with a greater challenge in achieving a given return level, demands a rethinking of active investing’s strategic role. With hindsight (always a dangerous, but unavoidably tempting, tool for analysis), there have been two reasons for the US$3.7 trillion global flow from active to passive investing over the past dozen years.

First, in aggregate, the active industry charged too much for what it offered in years past. Too many funds charged active fees for near-index performance, and there was too little evidence of repeatable success. Asset owners and consultants briefly flirted (misguidedly) with the concept of “active share” as a metric for active success, but that development played a role in capital migrating away from funds that demanded active fees for passive returns. Those funds are never coming back.

An upward-trending market was the second reason behind the massive shift of assets to passive. A passive allocation to stocks and bonds would have handsomely beaten inflation for most of the last 12 years, with a negative correlation between them to boot. Why bother paying for active management in such a world? A passive stock/bond investment could fill the need for any asset owner who needed to beat inflation, which we suggest is the true benchmark for investors, including individual retirement savers, many state and national pension plans, sovereign wealth funds and endowments.

The rising market rationale for the passive wave no longer applies in the post-pandemic world. The outlook for equities will likely be positive in real terms, albeit lower than before. Perhaps US government bonds can deliver returns in line with inflation, but that’s a more difficult task globally. So far, 2022 has delivered the shock that these asset classes are no longer as mutually diversifying, which we think sets the tone for coming years. Central banks are much more hawkish, macro uncertainty is radically higher and inflation is likely to settle at a higher equilibrium level.

In the context of this very different investment regime, we invite investors to reconsider the strategic case for active management. We’ll lay out the main supporting arguments behind this case in the rest of this paper.

Argument One: Markets Less Likely to Trend, Central Banks More Active

In recent years, when we’ve been asked where we were in the business cycle, our response was that there wasn’t a business cycle anymore—it had been swamped by government policy decisions. Well, the business cycle is clearly back now.

We now find ourselves in an environment where central banks are much more proactive. Also, the pre-pandemic status quo, with the business cycle stretched to lengths of time never seen before, has been shattered. Add in new forces of deglobalization (see Investing in a Post-Global World) as another variable that disrupts the pre-pandemic norm, and the result is that markets are much less likely to be trend-bound.

This mix implies a better opportunity for active approaches to help enhance end-client returns, a markedly different environment than the past decade, when multiyear trends became entrenched and there was no conventional recessionary cycle.

The active-management industry has faced heavy criticism over the past two decades that a lot of apparent alpha is just beta in disguise. If markets are no longer trending, a beta-masquerading-as-alpha strategy is harder to pull off, but we would argue that the industry has already adapted to discount such pseudo alpha. An investment environment that makes it harder to follow a persistent trend suggests, at least in theory, a greater role for active management. Of course, this presumes the existence of skill, a point we’ll return to later in this piece.

Most of the research here is concerned with long-run strategic allocations, but articulating a case for active investing requires some evidence that an opportunity set for active managers actually exists. One of the most effective ways to gauge such an opportunity over shorter time horizons is to assess the degree of correlations in markets.

The average pairwise correlation of stocks and the pairwise correlation of factors has been cyclical (Display 2). There’s been much debate about whether correlations in markets were trending higher, possibly driven by passive investing, central banks or globalization, among other forces. However, we think history clearly demonstrates that the key force is cyclical: exogenous shocks, such as the pandemic, push correlation higher, and correlations then naturally revert to the mean.

The correlation of factors is low right now, implying a high degree of “factor richness” in the market, which we think is a contributing reason for the pickup in the effectiveness of factor strategies in 2022. Stock correlation has risen somewhat, as macro stress has risen, but remains far below previous levels. This implies an above-average return for active strategies in the year ahead.

We also note a historical relationship between the ability of value-type strategies to perform and the average performance of active managers. We’re not saying all managers need to follow a value approach, but this relationship suggests that environments with larger intra-asset-class valuation dispersion are more fertile ground for security selection. Dispersions, by this measure, have compressed somewhat this year, but are still very wide historically. Moreover, in an environment where most asset classes are fully valued, the largest valuation spreads are within asset classes (Display 3).

Argument Two: Lower Expected Beta Returns and a Bigger Role for Persistent “Alpha”

In hindsight, one can say that the past decade was a very fortunate period based on historical returns and risk measures—simple beta exposure to almost any major asset class delivered positive real returns with historically low volatility. Over the next 10 years (represented by the arrows), we expect a much more challenging environment (though not bearish) (Display 4). It will feature lower real returns and higher volatility, driven partly by higher asset-class volatility but also by lower stock-bond diversification. 

This is the central challenge for asset owners: the information ratio, in real terms, seems destined to fall. To counter this, asset owners will need to add more risk—as efficiently as possible, subject to investors’ specific governance or liquidity constraints. We suggest the following main dimensions for adding risk:

• More private assets
• More leverage
• More factor risk
• More active management
• All of the above (in combination)

The decision to invest in active versus passive should be seen as part of the strategic asset allocation decision. A key challenge for the future of strategic asset allocation, therefore, is providing an analysis and narrative of how these risks fit together, the extent that they overlap, how they link to the macro environment and the level of conviction investors have that any of them will persistently be helpful. An important question for the industry (and our own research program) to analyze will be the extent to which the returns generated from an active fund allocation, a factor investment strategy and a private asset, for example, are mutually diversifying.

The key in adding more active exposure is for alpha to be persistent, so we think it’s critical that active managers are assessed on idiosyncratic alpha—not simple excess returns. The surge in “smart beta” exchange-traded funds enables asset owners to access simple factor beta at scale and at very low cost. This raises the bar for active managers: they must now demonstrate the ability to earn excess returns above simple factors, such as value, momentum or low volatility. But it also clarifies the kinds of active return streams that will likely be useful. Our research has shown that idiosyncratic alpha is more persistent than simple excess return, and a more reliable way to evaluate managers and strategies across different universes.

As evidence, future idiosyncratic returns are more significantly linked to prior idiosyncratic returns than is the case for simple definitions of excess return (Display 5). We think there’s a strong theoretical rationale for this, too. If a manager has genuine skill in stock selection, for instance, and constructs its portfolio so that stock selection is the dominant return driver (equally important), it’s less likely to be adversely affected by a sudden factor-leadership change in the market.

Put another way, we think idiosyncratic alpha is a superior way to measure manager skill than alpha as defined by excess return. We can show that the link between idiosyncratic alpha and persistent alpha applies to fixed-income funds as well as equity funds.³ The debate about the existence of skill in the active industry will always rage—but the “beta hurdle” that active managers have to overcome seems set to be lower in the years ahead.

Argument Three: Fee Budgets Will Likely Skew Toward Idiosyncratic Alpha

Fees have been a key motivation for the shift in active versus passive allocations. While lowering fees is a laudable goal, one needs to be clear about what the target should be. We would suggest that low fees are important because they’re a way to increase net-of-fee returns to the end investor. Maximizing that return should be the real goal asset owners set. Of course, it’s hard to know what that will be ahead of time, so the understandable shortcut is a focus on minimizing fees that are usually knowable in advance.

However, we think this approach is often dominated by heuristics, such as the notion that it’s acceptable to pay fees for alternatives but not for traditional investments. There’s a need for a holistic approach that addresses how an asset manager deploys its whole book in response to the challenge of lower returns and higher inflation.

A decade ago, the lion’s share of active investment by asset owners was directed to active public equities. That emphasis declined as a result of the extended strong performance of a simple passive long-only market position. We think different rules apply now. The largest fee allocation now goes to alternatives, not active equities (Display 6); within alternatives, private equity consumes the largest fee share (Display 7).

The defense of this state of affairs is that it directs fees to where they’re better able to add value, though this presumes a privileged position for private equity investments. We think this risks flirting with the same misunderstandings that surrounded active public equity investment in previous decades.

We argue that the historical average returns of private equity are unlikely to be repeated, given high starting valuations and the likely path of credit (see Private Assets and the Future of Asset Allocation). Private equity absolutely has a role in adapting a portfolio to a lower-return world, but we think such an allocation now seems more about alpha generated by a manager than the beta of overall private equity allocations. The dispersion of outcomes for private equity funds is much wider than for active public equity funds, so skill in fund selection does indeed deserve a high fee. However, wider dispersion cuts both ways.

We think the allocation to private assets and alternative investments should increase further; they’re important parts of the response to a new investment regime. As part of this response, we suggest that fee allocation requires a process akin to that for asset allocation, with fees ideally assigned in proportion to the contribution to real risk-adjusted return. It will enhance the process if investors consider asset allocation not only in terms of asset classes, but also on a more fundamental plane of beta versus idiosyncratic alpha across all asset classes. The implication is that fee budgets are saved for managers who can deliver idiosyncratic returns—a large portion of which will likely happen in alternative assets, though not exclusively.

Argument Four: ESG Is the Core of the Active-Passive Debate’s Next Evolution

Aside from the macro forces at work on allocations to active management, changes are also coming from within the investment industry, which we think will definitively move further toward ESG. But we also recognize that the emergence of a world with higher-equilibrium inflation poses new challenges for ESG investing that haven’t been faced in the dozen years in which it has been a significant force in finance. This will likely bring changes to how the industry thinks about the definition of ESG investing.

There needs to be a greater distinction between what counts as passive or active in an ESG context. Simply screening out certain sectors or reweighting a portfolio to make its stated carbon footprint lower than that of a benchmark is, to paraphrase the famous Prussian, an extension of passive investing by other means. It may be an important part of how a given investor achieves ESG ambitions, but we’re not sure it counts as active investing. This issue is linked to the question of whether the cost of capital for a listed company is meaningfully changed simply by secondary market trading in its equities.

The evolving ESG definition points to a more clearly defined role for active managers in engaging with firms they invest in to achieve a certain ESG output, or by overtly integrating ESG with broader financial considerations when generating inputs for active investment decisions. These roles are mechanically harder to fulfill from a passive perspective because they require adopting an explicit view—there’s no equivalent to “let’s just buy the cap-weighted index” when taking a stance on ESG issues.

Moreover, ESG engagement and integration presume that investors know the relevant questions to ask, knowledge that requires an expensive research process. Seen in this way, the evolution of ESG-as-engagement lies at the heart of the next evolution of the active versus passive investment debate.

Argument Five: China’s Index Weight Raises Fundamental Questions About Passive Investing

An increasingly urgent question for investors in passive indices is: What weight should be assigned to China? To any investor who believes that the cap-weighted index is the default starting position for investment, China represents a fundamental problem—there is no real market weight.

To provide one example, MSCI followed a three-step process of changing China’s weight in its equity indices by adjusting the “inclusion factor” applied to Chinese securities. The factor started from 5% in 2018 and ended at 20% in 2019. According to the current list of active MSCI index consultations, there are no immediate plans to make further changes.⁴

The resulting weight of China in the MSCI All Country World Index (ACWI) currently stands at 3.6%, making it the fourth-largest country allocation in the index. Full inclusion would push China into second place, as it would imply a much larger weight, in the 15%–20% range, substantially more than the current second-place country, Japan, at 5.5%. The implications for the MSCI Emerging Markets (EM) Index would be even more dramatic: China is already the largest exposure in the index by far, with a 31% weight. Full inclusion would increase its dominance, likely pushing it to nearly half of the index.

FTSE Russell followed a similar process when adding China A-shares in four tranches from June 2019 to June 2020, with an inclusion factor of 25%. The weight of China A-shares in the FTSE All-World and FTSE Emerging Markets indices closely matches that in the MSCI ACWI and EM, with a 4.1% and 37.4% weight, respectively. FTSE has also confirmed that it has no immediate plans to increase the China A-shares weight.    

Our note is strategic, not focused on the minutiae of weighting decisions, but the China weighting raises foundational issues regarding the nature of passive investing. It reveals that passive investing doesn’t obviate the need for active choices. This should be obvious, since all market indices require rules that are ultimately arbitrary—though they are usually at least transparent. This has been true ever since Charles Dow first calculated his average of prices to provide a journalistic narrative of market events. We think the choice of an inclusion factor for a market like China will always require a large dose of qualitative rather than quantitative input—stated requirements of capital controls and market access notwithstanding.

Any further advance of market reforms in China would prompt a question of whether to increase the representation of Chinese stocks in global indices. But what if this happens at a time when more investors are wary of such a shift, given current US-Chinese tensions? And what if such a shift would clash with an expanded set of ESG-type considerations for some investors? These questions have already been raised by clients. There would be consultation on them, but one can easily imagine different asset owners reaching profoundly different answers.

Beyond the uncertain path of China’s index weight, there’s a question of what changing the weight would do to the nature of passive equity investing. Until now, passive equity indices have been dominated by open capitalist societies operating within a globalized US-led order. A larger weight for China would change this dynamic for the first time—a place passive investing has simply never gone before. What does passive investing mean when applied to an economy whose government plays a significant role in its planning and direction?

We’re not making a value judgment about this issue—we’re merely pointing out that it would cause a fundamental shift in the nature of passive investing, stretching the term “passive” to the point that a different term may be warranted.

On the active side of the ledger, by contrast, China offers a sizable opportunity. This is a different angle, but germane to our overall subject. As strategists, we frankly struggle to make a directional case for exposure to Chinese equity beta, given the pronounced role of China’s government in the economy. It’s a political call not in the usual realm of quantified models. However, when we assess the availability of idiosyncratic alpha by active managers in different regions, China stands out (Display 8).⁵

As a final point on this topic, our deglobalization paper notes that a lower regional correlation within asset classes will likely be a key diversification source, making up for some of the shortfall from traditional equity-bond diversification. For this reason, there’s less incentive from a risk perspective for investors to buy a global passive asset class.

Argument Six: There’s Really No Such Thing as Passive Investing Anyway

It’s easy for people employed in the industry to be blinkered by labels—after all, they’re a fixture of our world, with “active” and “passive” regularly used by asset allocators and those responsible for running investment funds. Passive might carry connotations that it’s a default approach to investing—one that has obviated the need for decision-making. However, it’s actually no such thing.

To adapt an expression of noted economist Milton Friedman, investing is always and everywhere an active phenomenon. There are two ways to come to the notion that there’s no such thing as passive investing, and if they weren’t apparent before, they should be now: changes in the macro backdrop and changes within the investment industry itself.

From a macro perspective, persistently higher-than-average inflation will make it much harder to achieve positive real returns. For many investors, the ultimate benchmark they should care about is meeting “liabilities” set in the real economy, such as meeting the cost of retirement. That means inflation should be the benchmark. Seen in this light, any deviation from that benchmark would be an active decision.

As for industry changes, we’ve previously highlighted the explosion in the number of indices over the past decade, producing a paradoxical situation where there are many more indices than stocks. Based on recent estimates from the Index Industry Association, there are now around 2.4 million equity indices and about 43,000 listed stocks globally (Display 9). That’s roughly 55 times as many indices as stocks! Clearly, investors still must make an active decision even in picking a “passive” index. 

The investment industry has become benchmark obsessed, but this section can also be thought of as a reminder to investors: don’t lose sight of what benchmarks are actually for. They can be used to hold active managers to account, ensuring they’re delivering on their mandates and worth their fees. We argue that the benchmark, in that sense, is now a multivariate entity that needs to include cheaply attainable factor exposures.

A benchmark can also be seen as the reference level that needs to be met, which, for many investors, should be set in the real economy rather than by a weighted selection of financial assets. These two approaches have been confounded in an era when financial assets have outperformed real assets; a reversal of this dynamic drives a need to revisit this distinction.

Conclusion

One of the things that keeps investing intellectually interesting is that the rules keep changing (one of the many reasons there will never be a “science” of investing). The narrative on active versus passive allocations, which has dominated flows and organizational structures in the industry for the last decade, needs to be updated for a new regime.

We once wrote a fictional note on the hunt for the ultimate index.⁶ It’s occasionally easier to express important points fictionally than within the staid confines of a financial-services publication. Passive investing has been an important force for change that has lowered the fees paid by investors—an advance that should be recognized as a social good.

This process will continue, but the rules need to change. A lower inflation-adjusted return on financial assets, a shift in portfolios to permanently hold more illiquid assets, the question of the role of China in investment portfolios and the evolution in the meaning of ESG investing all point to a need to revisit the active-passive distinction.

This position should not be mistaken for a defense of all active management—a position that was never tenable anyway. The hurdle for demonstrating added value in active management is idiosyncratic alpha, not just excess returns. That hurdle is necessarily harder to achieve, but idiosyncratic alpha makes it easier for asset owners to discern where active exposure benefits their allocations.

The active versus passive allocation question must be seen through both cross-asset and cross-public-private-asset lenses—the only way to focus on the true goal of maximizing net-of-fee returns. The new investment regime we face requires a rethinking of the role of active management in portfolios.

1Fund Management Strategy: The Silent Road to Serfdom: Why Passive Investing Is Worse than Marxism, Bernstein Research, August 23, 2016.
2 Lidia Bolla, Alexander Kohler and Hagen Wittig, “ Index-Linked Investing—A Curse for the Stability of Financial Markets Around the Globe?” The Journal of Portfolio Management 42, no. 3 (Spring 2016): 26–43.
3 Alla Harmsworth and Harjaspreet Mand, Alphalytics: Is There “True” Alpha in Fixed Income?, Bernstein Research, January 20, 2021.
4 “ Index Consultations,” MSCI.
5 See Alphalytics: China—the Nirvana for Active?, Bernstein Research, October 28, 2020, for more details.
6Fund Management Strategy: The Man Who Created the Last Index, Bernstein Research, November 23, 2018.