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Active management sector needs to shrink – Moody’s

The active management industry will have to shrink substantially, Moody’s Investor Services argues in a new report on the growth of passive investments.

Acknowledging that the flow out of traditional actively managed mutual funds into passive investments has been ongoing since 2007 with the rate increasing all the while, the report, titled Industry flows actively moving to passive, argues it is likely to continue to accelerate.

“Cursory logic would dictate that the market cannot have only passive investors – active investors will always be a necessary component for efficient price discovery. But the current one-third level of passive investments and two-thirds of active is not necessarily near an equilibrium point, and we expect the passive share to expand well above current levels,” the firm writes.

The reasons behind the shift have been well documented, including cost pressures, regulatory shifts and habitual underperformance, but it is the last of these three reasons that Moody’s gives as reason for its estimation that the active sector, as a whole needs to shrink.

Pointing out that there are more than 9,520 mutual funds, and 10,000 hedge funds, compared to 3,691 stocks in the Wilshire 5000 – and 505 stocks in the more liquid S&P 500, the firm said: “This overcapacity leads to investment mediocrity.

“Since true talent is limited and size works against the investor in the form of increased transaction costs and difficulty in identifying scalable investment opportunities. An investment truism, “Size is the enemy of returns” still holds. Finally, as returns become ‘average’, which they must, the end result to the investor is significantly below average after the effects of higher fees and trading costs.

As a result, it argues, if it is to survive the onslaught from passives: “a fundamental rethinking of the traditional active mutual fund industry as a whole is required, including a re-emphasis on investment performance over growth and marketing, and more discipline in curtailing AUM and management costs.

M&A not the answer

And, Moody’s argues, it is not just the number of players that need to diminish either.

In order to combat the trend, Moody’s said, a number of active managers that had not previously offered passive products have recently altered their strategies, and either made acquisitions or created new products to address the shift from active to passive investing.

And, while it points out that much of this investment has been in ETFs and smart beta, some of it has taken the form of active managers buying other active managers.

“These managers view M&A as a strategy to address the passive trend. However, although there may be cost synergies, in most cases, this type of M&A is not a long-term solution since it does not reduce the amount of capital managed by active managers, so overcapacity continues to hamper performance.”

Part of the Mark Allen Group.