‘Sharks’ Losing Ground to ‘Prey’ in Markets

SMITH BRAIN TRUST — Since the global financial crisis, “active” fund managers — stock pickers looking to beat the market — have lost ground to their “passive“ counterparts, as investors “shun stock pickers amid concerns over bad performance and high fees,” the Financial Times reports. Assets, for example, that are managed in passive mutual funds have grown 230 percent globally, to $6 trillion, since 2007. “In contrast, assets in active funds, where stock pickers try to beat the market, have grown just 54 per cent, to $24 trillion.”

This trend (according to FT) is set to continue. But finance professor Russell Wermers at the University of Maryland’s Robert H. Smith School of Business sees the financial industry "heading toward a better mix." Wermers adds just one caveat. Pinpointing the ideal ratio is tricky, as an excess of passive investing will enhance long-term anomalies in the markets. Conversely, an excess of active managers enhances short-term problems of liquidity. Think of it in terms of a predator-prey balance to a healthy ecosystem, he says.

Wermers, who directs the Smith School’s Center for Financial Policy, is referring to findings from his paper, Active vs. Passive Investing and the Efficiency of Individual Stock Prices. He recently expanded on that work, using a shark-prey metaphor, during the Centre for International Finance and Regulation Conference on May 24, 2016, in Sydney, Australia.

“It is very clear, and most of us have the intuition, that we need both the sharks (active managers) and the prey (passive managers). Forgive me — because that’s a bit too harsh because it’s a symbiotic relationship more than a predator-prey relationship — but we need both in the water to make the world go round properly,” he said, as reported by Australia’s Investment Management magazine.

Financial Times notes the active-to-passive shift in mutual funds occurred with the global financial crisis. Prior, active fund managers thrived from buoyant equity and fixed-income markets. This enabled fund houses to gather assets quickly and charge high fees. Wermers adds that as markets have grown more efficient, the number of active managers needed for a level of equilibrium is shrinking because there is less need for price discovery. “This is conjecturing beyond my study, but this could be behind the move toward greater levels in indexing that we are seeing out in the marketplace, as prices become more efficient as technology and communication makes research more efficient and less costly.”

Wermers also told his audience of financial industry leaders, policymakers, regulators and academics that the stock holdings and trades of active and passive managers were correlated — but not to an “incredible” extent. “This is back in the predator-prey model," he said. "You are going to find the predators where the prey is: If a stock is traded pretty heavily by passive fund managers, then it’s going to be traded pretty heavily by active fund managers, but that doesn’t mean they are going to be trading in the same direction. The sharks are going to eat the prey; they are not going to swim with the prey.”