The value of active management in an uncertain world

Active and passive investment strategies have been battling for investors’ attention for many years.

In recent years passive strategies have seen massive inflows as cheap money fuelled a long bull market
and index strategies were able to achieve high returns cheaply, just by tracking their benchmarks.

When it comes to how investors are structuring their portfolios this year, the tough conditions of the past few years, and mixed outlooks for the new year, make a strong case for active strategies to take up a greater share of portfolios.

With increasing geopolitical and macroeconomic uncertainty, inflation stubbornly high and markets volatile, in 2023 we saw many asset owners turning to active managers to help them navigate the challenging environment.

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Some of the world’s largest asset managers including Japan’s Government Pension Investment Fund (GPIF), Norway’s Norges Bank Investment Management (NBIM), and our own Future Fund are increasing their use of active management in response to the changed market conditions.

But while institutional investors might understand the differences between active and passive management, and the roles each should play in investment portfolios, this level of understanding is not widespread among Australia’s broader investment community.

According to the latest Natixis Investment Managers Global Survey of Individual Investors, the level of understanding and knowledge about index funds amongst investors around the world was low; investors
are confused over the role passive investment has to play in their portfolio.

In the survey of investors with more than US$100,000 in investable assets, 61 per cent of respondents said index funds were less risky than active strategies, and two thirds (66 per cent) said that index funds can help them minimise losses. This data demonstrates the confusion amongst investors about the use of passive investments.

Are passive investments a lower risk approach for investors?
For some years there has been a perception that passive strategies can offer investors a lower risk approach to investing, the reality is quite different. While passive strategies can offer investors some diversification benefits, (over individual stock picking) passive investment has no inbuilt risk management.

Rather, passive strategies provide returns at market performance whether that is up or down, leaving investors at the mercy of the market.

Passive investments offer a basic value proposition: they give investors market returns at a lower fee. But investors have lost sight of that promise. In fact, just 63 per cent of investors recognise that index funds provide returns that are comparable to the market. More surprisingly, only 54 per cent recognise that index funds are supposed to be less expensive.

The role of active managers in uncertain markets
Active management may have higher fees but it is also more flexible and versatile, although there is still a place for passive strategies in the investment mix.

Active management can:

• Reduce volatility
• Provide better downside protection
• Create better diversification
• Provide higher income 
• Be better aligned with investors’ personal values
• Act more quickly when markets and conditions change
• Take advantage of short-term market reactions, to create long-term value for investors

In recent years, market conditions have shifted such that an active approach, where returns are driven by a skilled manager, are outperforming index funds. Speaking at the AFR Alpha Summit last year, Future Fund CIO Raphael Arndt highlighted the rationale for shifting the fund’s equities allocation back to active management: “Conditions have changed. As a result, active alpha-seeking strategies in our $65 billion listed equities program are increasingly attractive, provided that we can be confident that returns are driven by skill and not luck.... Skill is rare, and expensive. Paying sometimes high fees to fund managers is necessary to access skill,” Arndt said.

It’s food for thought for investors solely wedded to passive approaches. According to the latest Morningstar Active Passive Barometer, 57 per cent of active funds beat their benchmarks for the 12 months to June 2023. While there is a sense of optimism for 2024, with interest rates likely to have peaked in many parts of the world, volatility and market uncertainty remain high – conditions which are better suited to active management.

Actively managing ESG factors
While many investors recognise that ESG crises can affect stock prices as much as more traditional economic challenges, many individual Australian investors are now lagging behind the rest of the world
when it comes to ESG investing.

Our Individual Investor survey showed how allocations to ESG investments have changed in just two years. Back in 2021, 21 per cent of global and Australian investors had ESG investments. Fast forward to 2023, and globally, the figure has grown to 49 per cent. In Australia, we lag our peers with 37 per cent now invested in ESG.

So, why are Australians falling behind global averages? The rationale falls between those who said they don’t know enough about ESG investments (46 per cent) and those who “can’t tell if they’re making a difference,” both answers signalling a knowledge gap among Australian investors when it comes to responsible investment.

Additionally, the high focus on resources stocks in the ASX (and index funds), and commodities in Australia has made Australians more hesitant to switch to ESG investments. There’s also the issue of performance, with many ESG funds underperforming in the last couple of years. 62 per cent of Australian investors named underperformance as the number one reason they would reconsider their ESG investments.

Moreover, ASIC’s focus on greenwashing as an enforcement priority for 2023 has turned the spotlight on ESG funds, and whether investments are truly as green as they say they are. ASIC is particularly focused on the way funds represent themselves publicly, including any claims funds make on the sustainability or active ownership of their operations or investments. Concerns around greenwashing were named by 37 per cent of investors surveyed as a significant factor behind them reconsidering ESG investments.

Despite these headwinds, we know Australians are interested in ESG investments: both from anecdotal conversations with funds and investors and by looking at the data. For example, 61 per cent of Australians said if a fund demonstrated a better carbon footprint than others, they would be more inclined to buy.

When it comes down to it, 83 per cent of institutions globally are implementing some form of sustainable
strategy in their portfolios, and we believe that Australian investors have the appetite to catch up to their global peers. 

It seems investors also agree that there’s a role for big investors to play in pushing the needle on companies’ transition to becoming more sustainable: 69 per cent of Australians surveyed said fund managers should be engaging with companies on sustainability issues (vs 77 per cent globally). 

How to play 2024 – a time for active management
While we are still in the early days of the new year, it seems there is little consensus from global institutions on what the market outlook will be for the year, and whether we are heading for a bull or bear market.

One thing that is clear is the strategies that worked well in the past may not be as effective in the future, so it’s important that investors regularly re-examine their portfolios to decide whether they are still right for
today’s economic landscape. We think investors should be looking at the big calls for the market and assessing their own level of risk tolerance. While there are no clear answers, there will clearly be winners and losers. 

For investors, it’s an exciting time, and we believe that an allocation to active management, using a skilled manager, may provide investors with greater diversification, resilience and, ultimately, better performance in challenging conditions. 

Many of our institutional investor clients are looking to position themselves for an uncertain future by diversifying across asset classes and increasing their allocations to active management. We believe this is a prudent approach for retail investors as well.

Louise Watson is managing director, Australia and New Zealand at Natixis Investment Managers