Opportunities in Equity Funds

Given the growing popularity of passive index funds, what’s an active asset manager to do? Some savvy fund firms are

REUTERS/Jose Manuel Ribeiro

developing reasonably priced active products that maintain style and capitalization consistency much like passive strategies while attempting to avoid the shortcomings of index products. This likely represents a trend that will gain momentum.

There are some rules-based and enhanced products currently on the market, both as open-end funds and exchange-traded funds (ETFs) that combine passive-like discipline with an element of tactical active management. While these types of products haven’t proliferated as of yet, it is an area where fund firms can look to innovate to fill a need in the marketplace.

Actively managed equity funds – long a primary driver of revenue for the industry – are having their epitaphs written repeatedly by industry watchers as their flows remain in a pronounced funk. It is little wonder with the seemingly endless stream of net redemptions coming out of the category.

In fact, active domestic (U.S.) equity funds have shed $135 billion, $268 billion and $442 billion over the past one-, three- and five-year periods, respectively. Over the same periods, passive equity funds have taken in $165 billion, $370 billion and $561 billion, respectively.

Lately, there’s been a reprieve. From Dec. 19, 2012, through the week that began on Feb. 6, 2013, equity ETFs have experienced inflows six out of the eight weeks. The recent surge in equity flows has been nice for the asset class, but it will need to be sustained for a much longer time before the tide is considered to have turned. Right now it could be perceived as a fairly classic “January Effect.”

It seems that outside of passive strategies and some income-generating products, equity funds can’t seem to consistently generate inflows. Is it truly the end for active equity, as some analysts are predicting? Hardly – it’s too important an asset class, in our view.

But where are the opportunities for equity products? Fund professionals need only look deeper into the trends to see that equity remains a vital asset class and that there absolutely will be demand for products beyond purely passive strategies.

Consider the move toward fee-based accounts both here in the U.S. and abroad. Increasingly, advisors overseeing these accounts are using registered-representative-as-portfolio-manager (rep-as-PM) or fund-of-funds structures to implement different strategies for their clients. These strategies run from risk-targeted and income-generation to goal-oriented and horizon-based, or a combination of some or all of the above.

These are diversified portfolios that include varying allocations to equities based on risk profile, but, more importantly, they subscribe to a targeted approach. Advisors need products that deliver specific and consistent exposures. The dilemma of portfolio constructors in building these products is how best to incorporate the benefits of equities into targeted strategies. Go-anywhere funds may not be their friends in this regard, as they can end up with unwanted risk biases and exposures in their portfolios.  As a result, opportunities exist for product development executives to build products in a manner that harnesses the strengths of equity strategies both as an asset class and as a diversifier.

It’s easy to see why advisors often opt for passive products or ETFs: They can truly know what they’re getting from a risk and exposure point of view, and they don’t have to worry that the fund’s holdings will change dramatically over time.

However, advisors must live with some of the long-standing downsides of passive strategies – such as over-investing in overvalued securities and under-investing in undervalued securities, to name a couple. The right mix then would be an active yet disciplined equity product, which admittedly sounds a lot like rules-based or enhanced index portfolios.

Products that provide passive-like adherence to their style or capitalization objectives, for instance, while avoiding the downsides of pure passive could prove quite attractive to these portfolio builders. Such a category as described here is not yet a recognized genre per se, but there are several management styles out there that have been executing this approach for some time – such as “true value” or equity-income offerings – and they are getting inflows.

Does this mean rules-based products will rule the day? Not necessarily. These products have been around for a while and they haven’t set the world on fire. They suffer from inflexibility similar to that of passive and quant-based products in that the rules can sometimes be helpful and other times they can be blind to potential dangers. Combining the disciplines of rules-based with the thoughtfulness of a tactical active element can be an even better option.

Overall, we believe that actively run products that are thoughtfully priced and maintain an adherence to their mandates may well find quite a bit of interest among advisors and investors. True, such disciplines may not provide the opportunity for “shoot-the-lights-out” alpha relative to their benchmarks, but they could certainly cover their associated fees and then some. To be successful, such active products must provide, at the same time, a consistent equity exposure that also serves its purpose as an asset class within a diversified and risk-targeted portfolio.