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Active fund management is still relevant albeit for a different reason

Active funds need to focus on their ability to drive social change, besides giving alpha

The debate on the relevance of active fund management has grown louder in the past couple of years, centered around the ability of these funds to outperform the benchmarks. Most fund managers work with a mandate that eventually makes the fund quite similar to the index, so outperforming the index (especially one made up of larger companies) consistently has not been an easy task.

Enter index funds or passive funds. As the name suggests, these funds simply invest in the stocks that make up an index in the same proportion. No active effort in stock selection means lower costs that are supposed to translate into a better outcome for investors. Now imagine a world made up only of passive funds. That would obviously spell the death for active fund managers, but this is the reality in the making.

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The tsunami of inflows into passive funds over the past decade coupled with outflows from active funds has meant that in the US, passive funds have a bigger slice (bit.ly/3fbbyvF) in the AUM (assets under management) pie. In India, even a part of your Employees’ Provident Fund (EPF) finds its way into a passive equity strategy via exchange-traded funds (ETFs).

While the costs associated with running a passive strategy are minimal (in some cases, even zero), there is another cost to this—the concentration of shareholder power. BlackRock, Vanguard and State Street, known as the Big Three, control 80% of the US index fund money.

This also makes them very large shareholders in individual companies. As a Bloomberg article (read bloom.bg/31TC5tK) states, “22% of the shares of the S&P 500 company sits in their portfolios, up from 13.5% in 2008." This rise and concentration has been so spectacular that it led to the father of index funds, Jack Bogle, sounding a cautionary note about it in an op-ed in the Wall Street Journal (read on.wsj.com/3gHOJAh). ‘‘I do not believe that such concentration would serve the national interest," he wrote.

That sounds ominous so here’s the context. For a stock to make it into an index, it has to meet certain criteria based on a formula and isn’t much room for individual discretion. Since index funds mirror the index, they aren’t really bothered by issues such as corporate governance, sustainability practices, and diversity and inclusion. And if the shareholding pattern is going to be concentrated in the hands of an oligopoly of indexers, there isn’t much incentive for them to push for better management, practices or even innovation and efficient capital use.

The fear is that it could lead to a cartelization of votes by the members of the oligopoly and they, in turn, would drive the narratives around most companies. A Harvard Law paper (read bit.ly/3fdeU1h) estimates the share of votes held by the Big Three at S&P 500 companies will be 41% or more in the next couple of decades if these trends continue. The Big Three are aware of this and the CEO of BlackRock recently said, “We must be active, engaged agents on behalf of the clients invested with BlackRock" (read bit.ly/2ZSJk2i). In short, they’re aware of their role to vote responsibly and push for better from companies.

Now it isn’t like active fund managers have done a great job so far in pushing for better behaviour from companies and poor practices can continue to get rewarded even under this system. Data on voting patterns suggests that mutual funds tend to favour most corporate decisions (read bit.ly/31Sxqs5).

But as a growing segment of today’s investors focus on issues that matter and social causes, this is where active fund managers can sell themselves and their research abilities to push for better governance and, thus, further their cause. Rather than just shout about their ability to deliver alpha, they need to focus on their ability to drive social change and take this seriously. Active fund managers can become more relevant by rewarding companies with a strong set of values and intent.

There is no doubt that a market like India is different. Companies still have significant promoter ownership and index funds are still too young to be of much bother. So that’s a problem for another day. But active funds can get a head start today and ensure they don’t fall into the same rut as their global counterparts if they take their role of being stewards of investor money a little differently and actively.

We’ve a long way to go before this becomes the norm but if we don’t talk about it, we won’t get there. Also, decisions around a values-based system aren’t objective so we will continue to learn along the way. But it’s time we change.

Nithin Sasikumar is co-founder of Investography

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