Implementation not methodology holds the key

The age old ding dong between active and passive management continues to command plenty of airtime but neither side is close to landing a knockout punch. In many ways it is an impotent and somewhat flawed debate.

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The age old ding dong between active and passive management continues to command plenty of airtime but neither side is close to landing a knockout punch. In many ways it is an impotent and somewhat flawed debate.

By James d’Ath

The age old ding dong between active and passive management continues to command plenty of airtime but neither side is close to landing a knockout punch. In many ways it is an impotent and somewhat flawed debate.

Beyond the rather pedantic point that there is no such thing as passive investment, only ever decreasing degrees of active management, the real issue is not about who has the best investment methodology. If we had a definitive answer, our academic brethren wouldn’t be furtively publishing reams of studies and white papers on the subject, each enthusiastically hailing their latest work as definitive.

The truth is, active management is here to stay, although how it is delivered is fast becoming the more pertinent question. The traditional fund vehicle, with which the UK market is so familiar, is broken. Granted it provides plenty of protections, but is an unwieldy and cumbersome structure which suits neither the provider of investment management nor the end investor.

In short, forget about the self-serving ‘active versus passive’ noise, move beyond investment methodology and look at implementation. End investors are becoming more discerning and sophisticated and how they access a particular methodology is becoming increasingly more relevant. As active managers fight to justify their opaque fund cost structures and in some cases their very existence, they would do well to take a step back and take this point on board.

To explain this in more detail, it is worth taking a sideways glance at funds to illustrate the point. Why do investors buy a particular fund? It could be any number of reasons, so let’s look at the six most common:

  • Access to a particular asset class, geographic region or categorisation
  • Diversification
  • Performance
  • Investment Manager reputation
  • Cost
  • Regulatory protection

In most cases, investors will cite at least two of the above, as reasons for investment. But what if there was an alternative way to access these investment criteria whilst circumventing the cumbrous fund option? Accessing an active manager’s methodology or IP can now be done via a more efficient process. The net result is lower costs, bespoke investment vehicles and an instant uplift in performance.

So how is this supposed alchemic feat achieved?  The answer comes from the oft berated (and at times rightly so) world of investment banking. Synthetic replication and trading has been used bank to bank for a number of years, but is now being used to unshackle investment mangers’ IP, enabling them to lower costs, improve performance and access a greater range of investors at a stroke.

This alchemy does have its limitations, in that in order for an investment methodology to be replicated, it must be disciplined enough to be able to extract sufficient rules to create a synthetic version.

This is not to say only asset managers with highly ‘active share’ portfolios can be replicated. On the contrary. The synthetic replications should not be confused with reference benchmarks that carry little or no investment intelligence. The purpose of their implementation is to free up an asset manager’s IP, which under the current arrangement, is being suffocated by increasing regulation and ever greater scrutiny on fees, performance and transparency.

Funds will not disappear overnight. Indeed it would be churlish to cheer their demise. However, change is needed if the industry is to flourish and squabbling over the pros and cons of who has the methodology is facile. The asset management industry needs to engage fully with the new and exciting alternatives to funds and credit their end investors with a little more nous than they currently do.

Like any market, demand drives supply. As investors continue to develop their collective understanding of financial markets, the demand for the next wave of alternatives to funds will take hold. Look beyond investment methodology, accept we will never always be right and therefore by definition never always be wrong. Instead look towards the implementation of your chosen strategy and to the alchemists working beyond the status quo.

 

 James d’Ath is director of Indexx Markets

 

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