Foundation & Endowment Report: Active Management Isn't Dead

August 1, 2017

Foundation & Endowment Report's August Issue featured NEPC's Kristin Reynold's story "Active Management Isn't Dead."

Active management vs. passive management has been discussed ad nauseam, both within the endowment and foundation community and in the media. But despite the widespread headlines proclaiming that active management is dead, our conversations with endowments and foundations tell another story: the market has reached a point of equilibrium and large institutional investors still place significant value on skilled active management. According to a survey we conducted in May, just 7% of endowments and foundations plan to substantially increase their use of passive management within the next year. The majority – 51% – plan to maintain their current exposure.

For many investors, active management historically offered an asymmetric risk/reward profile, where the expectation was that active managers would protect during market downturns and keep pace, for the most part, in positive trending environments.  Ultimately, this would lead to active management outperforming over a full market cycle. The current bull market for U.S. stocks (which has now lasted more than eight years) is the second-longest in history and has been driven by global liquidity, but dotted with continued worries of economic downturn. Despite some interim volatility, U.S. stocks continued to rise, and this has proven to be a struggle for many active managers. A market downturn will surely happen at some point, and that’s when investors historically have wanted protection in the form of active management and other strategies offering performance that can deviate from that of “the market.”

Even with signs that the economy continues to improve, our most recent survey indicates that many investors are concerned about new risks. More than half (57%) of the endowments and foundations we surveyed in May think the U.S. economy is in a better place now than at this time last year; this was down seven percentage points from a similar survey we conducted in January. We also found that investors are less worried about a slowdown in global growth and more worried about geopolitics and political uncertainty (compared to consensus views in 2016). Thirty-seven percent of endowments and foundations cited the latter as the greatest threat to their near-term investment performance. If this view drives behavior, we could see investors increase exposure to actively managed strategies in anticipation of a market downturn.

Many endowments and foundations – especially small and midsize ones – may also feel they need to be more aggressive in their investing strategy to reach for returns that were once the norm. Reflecting on the last several years where active management struggled in certain segments of the markets, investors continue to rationalize their active exposure. We’ve seen our clients refocus their portfolios towards active managers that are in less efficient markets or active manager that can look very different from a benchmark.

In the future, we expect to see more asset owners revisit where they should pay for active management to pursue excess returns, and where they should seek lower-cost passive exposure. Many have already identified emerging market equities as ripe for active management, as the middle class expands in many EM countries such as India, Pakistan, Indonesia, and Nigeria. Nearly two in five endowments and foundations – 39% – think emerging market equities will be the strongest-performing asset class of 2017; just 14% have used passive management for their EM equity exposure or are considering doing so in the near future. Performance in this asset class tends to be volatile, as China’s recent economic struggles indicate.

Certain other areas, such as U.S. large cap equity, may be better suited for passive management. When we asked about the asset classes where endowments and foundations have opted for passive management, an overwhelming 93% cited domestic equity. Many investors clearly believe they’re better off with the market return of U.S. equities (at low cost) than trying to beat the market.

Investors may focus on higher fees associated with active management; in fact, 39% of the endowments and foundations we surveyed cited lower fees as the primary reason they were drawn to passive management. However, concerns about fees have dissipated in periods when actively managed funds have provided substantially higher returns.

Finally, it’s worth noting that the widespread adoption of passive management is by no means universal. Some endowments and foundations exclusively use active management. Thirty-nine percent of our survey respondents have less than 10% invested via passive management, and 13% said they don’t use passive management at all.

A number of factors (including the extended bull market and political uncertainty both in the U.S. and the abroad) may render active investing more attractive to endowments and foundations in the coming years. We expect to see more investors utilize both active and passive management in their portfolios, paying close attention to the relationship between returns and fees.

Read the story on Foundation & Endowment Report's website here.

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Topics: Endowments & Foundations, News, Press Coverage

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