Episode 94: The Case for Active Management

Speaker A: Foreign.

Speaker B: Welcome to the at the Forefront podcast. I'm Sam Belden, Head of content at Forefront Communications, joined today once again by David Choate, Chief Operating Officer at capis, which is an institutional brokerage firm based out of Dallas, Texas. Dave, welcome to at the Forefront.

Speaker A: Thank you very much Sam.

Speaker B: Good to have you with us today. Um, so today's episode is focused on one central question, uh, which is what happens to public markets when fewer participants are actively making decisions about value and price discovery? Um, much has been made, as most of you know, about the rise of passive investing in recent decades. And uh, Dave has been vocal about how this shift, uh, is impacting U.S. capital markets, uh, and the importance of active engagement in the price discovery process. Uh, so today we'll talk a little bit about the rise of passive investing, some of its implications, uh, the importance of active management in price discovery and market health, some of the policy and uh, structural headwinds around all of this, and then some thoughts on what this means for the future of public markets. So a lot to unpack there. But um, Dave, we'll start with um, the high level story that you're trying to tell. Um, can you tell us just a little bit about the role that active management plays in maintaining healthy public markets?

Speaker A: To make it simple and short, active management provides the single most important function that capital markets can provide to a company and that is the allocation of capital by merit. We need active management. Active management is key to our markets being successful. And I'm concerned that there are so many headwinds right now and uh, hopefully we'll get into these in the next few minutes, uh, that, that are promoting index ETF and other strategies and uh, frankly harming the active management community. And we need to find a way to reverse that trend.

Speaker B: Great, thanks for that overview. Um, so as I mentioned, um, much has been made about this rise of passive investing that we've seen in recent decades. Um, can you tell us how that has changed the way that capital is allocated in public markets?

Speaker A: Well go back and consider where passive investment investments began. They really began late 70s and started to get some traction in the early 80s. Uh, passive investments were seen as a unique strategy that would be alongside active management. Uh, over the years what we have found is that active management has been um, kind of taking a second a backseat to the passive strategies by regulation and uh, and other drivers. Frankly performance. Performance has been good in uh, in, in passive uh, in the 80s active managers routinely outperform and the further we go with a being uh, concentrated in passive strategies the harder it's going to be for active managers to outperform. Uh, you go back and consider how large investment companies were built. They were built on 40 ACT funds, on mutual funds and the success of those funds. Uh, indexes were merely a way to judge the performance of active managers. And today unfortunately, um, index funds have become the lion's share of the market. And it's a self fulfilling prophecy. It's hard to beat an index fund if all of the money is in the index fund. Right. And very little is uh, is active. Uh, but we go back to that first theme. Active management is the one area that provides the single most important function of capital markets. And that is allocation of capital by merit. We cannot let that die.

Speaker B: Makes sense. And so Dave, I know that you wrote in Institutional Investor a couple months back, uh, about how this isn't just a stylistic preference. Do you trust the index tracking machines or do you want a human making decisions? It has real implications for how markets function and the nature of capital allocation, what that actually looks like in practice. Can you give us a few examples of where you see that act? The, the, the nature of capital allocation changing based on active versus passive.

Speaker A: Okay, consider IPOs. Uh, the, the purpose of the capital markets is to functionally create capital. Companies come public. Uh, their stock grows in value based on their performance. Uh, their, their coffers get larger. They can, they can increase the services that they provide. Uh, and this simply they grow with their, with their performance. Uh, if I'm a, I'm a small growth company that I, I decide now to become public, you look back in the days of, of Microsoft and Apple and intel all coming public when they were relatively small, looking for that capital formation engine that was, is the US Stock market today. Small growth company might get put into the Russell 2000 fairly quickly. And unless they're a meme stock, they're going to get capital along with everybody else in the Russell 2000 because that's how the money is being allocated to by the public. Why would I want to do that? I'm a small growth company. I'll stay private. Private can give me 10 times my last funding if I can perform. Will the equity markets do that? The public markets? Not without active management. And we are moving further and further in that direction. And you can see it by the growth of private markets. Uh, you can see it by the fact that companies such as Tesla and the Starlinks and um, um, the rideshare services, none of them came public as a small company. They came public when they already had uh, gone through the initial growth phases. If the only interest is to become public after you've surpassed the growth phases and you're just going to be an average performance company, that's the only thing that's going to be left in our marketplace. So it's, it's noticeable when you look at the private versus public markets. It's noticeable when you see the regulators pushing to give pensioners access to private markets. We can talk about that later. One of the things not to do, um, but it is materially affecting the um, the engine that is capital formation in the United States, especially for the small and mid sized company that, that seeks to possibly go public. Mhm.

Speaker B: Hearing you talk through that, it's, it's almost, it's almost as if you're arguing that passive investing is sort of warping the original purpose of, of the public markets, the function that they were originally intended to serve. The function that that sort of um, made the U.S. like the, the top destination for, for capital formation, um, of the world's markets. Is that a fair way to characterize your argument?

Speaker A: Absolutely, absolutely. And it ultimately will have a flattening effect.

Speaker B: Yeah.

Speaker A: And when you really start to look at it, what, what would drive a small company to these public markets today? How can I get 4x my last funding? I can get it in the private market. If I perform. Will the public markets give me something similar? If the answer is no, we got a problem.

Speaker B: Yeah, that makes total sense. Um, well great. Thanks for that explanation. Um, I know Dave that uh, the role of commissions and research is another um, factor that is affected by this shift from active to passive. Can you tell us about how that fits into these broader dynamics um, around active management?

Speaker A: Yes, there's a, there, there's a tipping point out there. Don't know when we, we cross it. But active managers generally require research to do, to provide uh, uh, their services. That research is often provided by broker dealers. Uh, it's a nice function of our capital markets. Back in the 1970s we adopted a rule, Section 28E, an amendment to the 1934 act that allowed managers to use commissions for research. And those commission dollars accumulate at the broker dealers that can perform those functions effectively. Uh, as active management wanes and it has definitely been waning over the last 20 years, uh that function loses, uh, its payment mechanism. Uh, it's not easy to stand up after it's, after it's been lost. But active managers use commissions to acquire research as their commission budget shrinks. Because Aum um is going Passive. Uh, they, we speed up the um, uh, demise of active management and therefore the allocation of capital by merit. One step further, there is the ETFs. Uh, ETFs sound like a great idea and you can do active ETFs. Terrific. Uh, problem ETFs are generally the securities within the ETF. Uh, trust are generally traded by APs, authorized participants or market makers. Uh, that takes the trading decisions out of the hand of the active manager and therefore the commission budget out of the hand of the active manager. And that further speeds up their own demise. So there's an issue there with the ability for ETFs to uh, kind of be the solution when they're really part of the problem. Mhm.

Speaker B: Yeah, it's, it's. You're, you're almost describing like a, almost a downward spiral for active management where you know, you, you have these pressures that, that are making it more difficult to succeed as an active manager. And, and um, it, it just, each factor just sort of builds on itself to create a more difficult environment and a less robust capital formation ecosystem.

Speaker A: It is not too late to change it.

Speaker B: Well, we'll, we'll talk a little um, about that. But Dave, I know and um, that another aspect of your argument here is tax, um, policy as a structural headwind. Um, you've touched on this, um, in an op ed that you wrote for Traders magazine. Could you tell us a little bit about how tax policy enters these conversations um, and how that's influencing investor behavior today?

Speaker A: Yeah, this goes straight to the ETF front. And I know active managers have often tried to chase the new trend here. And the new trend being use an ETF as a wrapper, um, instead of a traditional 40 act fund for assets. Um, and the reason that has become attractive uh, is twofold. The first of which is generally not material to the long term investor. And that is the fact that they can be traded intraday. Okay. And a mutual fund trades uh, at nav at the end of day. Most investors for the long haul, which are most of us who are trying to retire, trying to uh, invest, uh, for retirement. Intraday trading is of no particular value. What we do want though is tax efficiency. Yes. And the ETF has a function within it that involves the transfer of securities in and out of the trust, uh, in exchange for creating shares or redeeming shares. The transfer, the transfer process allows the ETFs to avoid taxation. Any sale for cash creates a taxable event. A transfer of securities in exchange for other securities or in exchange for uh, the um, uh, creation or redemption of shares is not taxable. Uh, so ETFs become more tax efficient because of that function. Now what it creates is a lack of commissions for the active manager. So even though they have active ETFs, uh, they tend to cannibalize themselves by losing their uh, their. Their commission dollars. The ICI has uh, has been uh, vocal in their support of uh, what's called the Growth Act. And I would put my full support behind uh, the general idea of the Growth Act. The Growth act looks to uh, normalize taxation across these platforms by essentially eliminating the capital gains tax on uh, transactions within the 40 ACT fund wrapper, making them not only equal to ETFs, uh from a tax efficiency perspective, but also the active ETF could then be traded by uh, the active manager rather than uh, done by in kind transfer. Uh. Ah, and that helps rebuild the active manager's commission wallet.

Speaker B: Great. Um, well Dave, we've covered a lot of ground in this conversation and it all sort of adds up to a perfect storm of pressure on active management. So, so what in your opinion needs to happen, whether on a market structure front or in terms of policy to ensure that public markets remain healthy and competitive in this environment? What's your opinion?

Speaker A: Three things. Taxation, regulation and public opinion. M. So taxation, we just talked about it. The Growth act would be a terrific. And uh, I need to spend a little bit more time understanding all of the nuances of any piece of legislation because there's always things added to it. But the general idea, the Growth act that uh, we normalize the uh, taxation across both the ETF and uh, mutual fund platforms would uh, be a great start. Um, but all three of these have to happen, not just taxation regulation. We've got regulation right now that promotes index investment options as default options for 401ks, for um, uh, retirement plans, uh, and making it frankly difficult for a wealth manager to choose anything but an index fund. Consider it risk that they would choose something that uh, has possibly higher fees. Uh, we need to consider regulation at the advisor level and including the employer level that uh, would encourage the selection of active management, uh, uh, for their participants. Um, also on the regulatory front, make it easy for corporations and frankly attractive for corporations to become public again. Uh, all of the regulations that, that restrict accounting, um, board makeup, uh, compensation, all of the things that are hampering the desire of a company to become public, uh, are hurting the uh, the markets. Consider that a public company, a, a private company would rather go to a venture capital firm. Than come into the public markets. Years ago we would have thought that the craziest idea because venture capital obviously is going to have some strong demand. They'd rather have that than uh, than be part of our public markets. That tells you the regulations are overbearing. We've got to fix that. And uh, number three, public opinion. Public opinion has to change. Public opinion has to recognize the importance of active management and got to follow it. You saw public opinion and you may or may not like this comparison. Uh, but we stopped wearing fur coats. Not because they didn't keep us warm, but we knew we were destroying an ecosystem of nice cute little bunny rabbits, uh, and the forest. I can't make the financial markets that cute, but we are destroying the ecosystem that is our financial markets. And the public has to see it and uh, and, and want to seek out active management in the same way they wanted to seek out a, uh, another warm coat option.

Speaker B: I think that's a perfectly good comparison. Even if, uh, our capital markets will never be quite as warm and fuzzy as uh, as what you're comparing them to, um, we could at least make them more resilient and more aligned with uh, as you say, merit and who deserves to win based on the fundamentals that dictate whether a company is going to be successful as opposed to inclusion, um, in an index. I think you made that argument well, Dave, so I appreciate you taking the time to hop on and uh, and make it today. Good conversation about why active management is essential to the health of our public markets and uh, some of the things that need to change in order to um, in order to restore it to, uh, the place where you believe it needs to be. Um, for those who'd like to hear more from Dave or keep up with broader, uh, commentary and updates from Capis, you can head over to capis.com um, and for more episodes about the Forefront like this one, head over to forefront comms.com and you can go over to the News and Insights tab for a full episode archive. So until next time. David Choate, thanks for hopping on today and uh, telling us about the importance of active management and everything that you're seeing, um, in that important uh, story.

Speaker A: Thank you very much.

Speaker B: Take care.