The explosion of data, along with developments in machine learning, constitutes the greatest new opportunity for active investment management in many years.
This is the view of Ronald Kahn, the global head of scientific equity research at BlackRock, who gave a presentation to Certified Financial Analysts at the recent CFA Society South Africa 2019 Investment Conference in Joburg.
In South Africa, we use the terms “investment manager”, “fund manager” and “asset manager” interchangeably to refer to an asset management company or, more appropriately, the investment team at the company.
These teams of investment professionals determine the investment strategies and make asset allocation decisions on our unit trust investments or retirement savings.
Kahn singled out index (or passive) investing and active management as the two predominant investment strategies.
The differences between the two strategies may be better understood by comparing two unit trust funds in the South African general equity category, the Absa Top 40 Index Fund and the Absa Core Equity Fund:
* The Absa Top 40 Index Fund is managed according to passive investment principles, which means that the fund management team aims to generate similar returns as a broad market index - in this case, the FTSE/JSE Top 40 Index. Absa explains: “This fund will track the performance of the FTSE/JSE Top 40 Index as closely as possible by employing full replication of the index.”
* The Absa Core Equity Fund relies on an active investment strategy that involves ongoing buying and selling activity by the fund management team. The fund’s fact sheet states: “The investment team applies a bottom-up, stock-picking approach, predicated on strong conviction ideas and attractive relative valuations.”
Investment professionals use the term “alpha” to refer to the return of an investment above and beyond the return of a market index or benchmark, which is “beta”.
Kahn introduced some of the trends informing the future of investment management:
Move from active to passive
There has been a steady migration of investor capital from actively managed to passively managed funds. “This trend is bad news for active managers, both practically and in a business sense,” said Kahn. It’s a well-known fact that the average active fund underperforms the market, and the preference for passive is because risk-averse investors are not prepared to take on the additional risk that an active investment strategy may require to achieve above-average performance, or “alpha”.
Big data analytics
Data and the application of data has evolved spectacularly over the past decade, regardless of industry. Firms operating in the investment management sector are trying to extract “traces of human behaviour” from large volumes of unstructured data. “Access to financial data is no longer the edge - it now lies in the effective analysis of this data,” said Kahn. BlackRock already uses computers to “read” and consistently analyse the thousands of stock reports that it receives from brokers each day.
The arrival of smart beta
Active investment managers are increasingly introducing passive techniques in structuring their portfolios. In a paper, “How smart beta is disrupting the investment management industry” and co-written by Michael Lemmon, Kahn writes that smart beta strategies are “active strategies with some of the characteristics of passive strategies (in that) they use simple, rules-based, transparent approaches to build portfolios that deliver fairly static exposures to characteristics historically associated with excess risk-adjusted returns”. Kahn expects the field of active management to evolve into two separate product types, namely smart beta products with lower fees and pure alpha products with higher fees.
“Like indexing, smart beta is about providing risk exposures as cheaply and reliably as possible - there are substantial benefits with scale,” he concluded. “Successful pure alpha strategies are rare, capacity-constrained and valuable and will continue to demand a cost premium from the market.”
Investing beyond returns
South African investors will be quite familiar with the concept of environmental, social and governance (ESG) investment principles. ESG shifts the investment decision from a pure consideration of risk and return to one that considers utility. Utility is an abstract concept described by economists as the satisfaction derived or expected to be derived from the consumption of goods and services. Expanding utility into the investment world allows for the partial sacrifice of investment return in favour of the broader socio-economic good.