What constitutes the greatest risk to active portfolio management? originally appeared on Quora, the place to gain and share knowledge, empowering people to learn from others and better understand the world. You can follow Quora on Twitter, Facebook, and Google Plus.

Persistent low volatility presents the greatest risk to active portfolio management, and complacency over potential downside risks have contributed to the rapid growth in passive index funds at the expense of active managers.

Volatility suppression

Highly accommodative monetary policies such as prolonged quantitative easing by the Bank of Japan and European Central Bank, as well as Federal Reserve’s on-going principal reinvestment program to maintain the size of its balance sheet, have effectively dampened market volatility by generating excess liquidity to support risk-taking in broader financial markets:

QE purchases by the ECB as well as Fed’s reinvestment would be used to purchase high quality assets to push down risk-free asset returns.

Savers and fixed income investors would respond to depressed risk-free returns by moving up the risk ladder and fund riskier investments (such as buying stocks or invest in corporate bonds despite being well into retirement age), a well-anticipated behavior known as “reaching for yield”.

Low interest rates allow corporations to issue debt to fund stock buy-back programs (a practice that is only sustainable under low borrowing cost and frowned upon as “value extraction”), such as Apple’s recent $10 billion debt issuance to buy back its own stock and to pay dividends; not to mention the added benefit of generating upside momentum to stock prices.

With global excess liquidity generation continue unabated, volatility are being suppressed by investors looking for the next opportunity to invest newly acquired funds.

“Why hire a fund manager when equity prices can only go up?”

Active portfolio managers have the potential and tools (note: only a minority of active managers live up to this potential) to offer investors downside protection, such as active risk management to reduce losses during downturns and increase risk exposure in anticipation of risk recovery.

A recent Goldman Sachs research note titled “An Rx for Active Management” by Robert Boroujerdi highlighted active managers’ ability to outperform in down markets (image credit: Goldman Sachs):

Nevertheless, this essential function of “risk hedging” becomes less meaningful amid low volatility.

An analogy could be made using health insurance as an example: young adults feeling “invincible” would be less likely to buy a policy compared to older individuals who are well aware of their health risks. If somehow people start to get sick less often, and chronic diseases become less common, it would be reasonable for more individuals to go without insurance.

In a low volatility world where central bank policies buttress risk asset returns, retail investors would wonder (for a good reason): “Why have someone else manage my money when equities can only go up? The [insert domestic central bank here] has my back.” Indeed, in a world where market exhibits little downside risk, everyone is an expert as long as they hold a long position. Perversely, cautious active managers who become unnerved with market distortion would under-perform the market by paring risk (image credit: Goldman Sachs):

Conclusion

In essence, the “Great Migration” from active to passive management funds reflected retail investors’ increasing willingness to forgo volatility hedging (partly due to heightened complacency, as well as disillusionment over some active managers’ under-performance), for active managers’ fees can be seen as a premium to protect investments from downside risk.

Thus, active portfolio managers face a multi-faceted challenge ahead:

* How to generate superior returns relative to the index during period of low volatility - preferably via alpha, but many would simply increase leverage (which would result in outsized losses during a downturn)

* Outperform index funds when the low volatility period comes to an end - likely as a result of central banks’ balance sheet policy tightening

* The next downturn will be crucial. Actively managed funds that outperform the market will live up to their advertised potential, and the funds that under-perform the index would justify investor skepticism and reinforce the view that “the paid experts are not doing any better than myself”

This suggests active managers who desire prolonged monetary policy stimulus and low asset volatility should also beware of resulting encroachment of index funds.

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