- David Herro, Portfolio Manager and Chief Investment Officer of International Equities at Harris Associates, participated in the debate “Shaping the Future of Active Management” at the Natixis Investment Managers Summit 2018, held in Paris
- Herro firmly believes that passive investors create market inefficiencies by investing irrespective of price and value
- When active managers do not resist the temptation of performing short-term, they start becoming quasi-passive managers and start taking short cuts, despite of collecting an active fee
According to David Herro, Portfolio Manager and Chief Investment Officer of International Equities at Harris Associates, an affiliated of Natixis Investment Managers, active managers need to be grateful for passive investing. As more money flows into passive investments, more investment decisions are made irrespective of price and value and more market inefficiencies are created.
“As an active investor, I actually need passive investors to have a field on which to play. When market inefficiencies are created, I can exploit these opportunities as a long-term value investor by taking advantage of these market distortions, and that is why I am very grateful to passive investing. This means there may be some short-term pain and our challenge as an active investor is to spend more time with clients while we are going through these periods. We have to explain to clients that they do not have to act irrationally based on short-term pricing events,” said Herro.
“If you are an active manager, you are not going to match the performance of the index quarter to quarter. If clients want someone who is going to match the performance quarter to quarter, that is not us. There is always a trade-off between trying to match the index and achieving long-term results. As an equity investor, I can invest in businesses that theoretically have an extremely long duration, and I am trying to take advantage of the shelf prices, knowing that the fundamentals are not changing anywhere near the prices. I need more than one or two quarters to do that, sometimes maybe a year or two. The active manager has to be out front and communicate that active management needs time to work. Additionally, transparency with clients is key. Each manager is kind of a tool in a tool box and clients need to know what type of tool you are as a manager and how you are intended to be used. Active managers need to be who they profess to be, so clients know how to use your skills properly,” he added.
As Herro explained, when active managers do not resist the temptation of performing short-term, they start becoming quasi-passive managers and start taking short cuts, despite collecting an active fee. As a result, when the cycle turns, those managers are not going to obtain their alpha back.
“We utilize discipline and patience in our strategies. This is something that is lagging in the investment world because some of the clients are short-term oriented. But I am glad that at our company we take the time to achieve long-term returns. Our system is designed to significantly and measurably outperform over 5, 10 or 15 years. We always try to take advantage of market dislocations, when share prices move in a vastly different direction or speed than the underlying intrinsic business value. When volatility comes back, it provides more dislocation to markets, which enables us to exploit future return possibilities. For example, on the last day of the third quarter this past September, the Italian government proposed a budget that significantly deviated from commitments agreed upon by all euro zone members. In general, there was an extreme dislocation in the European financial sector. The next day of trading, the European financial stocks were trading at an average down of 2% to 3%, and even quality Italian financial institutions were down 7% to 8%. Clearly, in our view, the business did not magically become worth 8% less, but because of some political discourse there was an extreme volatility in prices in a very narrow sector and we were able to take advantage of it.”
The hidden costs of passive investment
When securities are bought and sold, just in the dealing and exchange of the investment instruments, there is a margin between the bid-ask spread alone. Money is made just in the business of buying and selling spreads. “Whether it is through hidden costs, bid-ask spreads or not being able to get investments at the right price, these are all forms of hidden costs that might make ETFs less competitive,” said Herro.
New disruptive players
Herro believes that eventually tech giants like Amazon or Google will possibly get into financial services. “They will probably offer all kinds of products. They may offer passive products, but they may even offer some artificial intelligence type of product. To me, as an active manager, the more players the better because they create market inefficiencies. They have money chasing certain characteristics in size, location or industry, instead of value characteristics. As long as they can not develop a model that delivers long-term value returns, this is additive to our business,” he concluded.