Big forces in stock markets are making active managers a threatened species.

Like jungle cats finding existence tough as their environment changes around them, active managers feel pressure from passive investing and from investing done through — or even by — players without two scraps of human DNA to rub together.

Investing guru Howard Marks discussed this in his recent piece Investing Without People.

Marks said passive investing — including exchange-traded funds (ETFs) — and investing using computer algorithms and machine learning, seemed to be reducing the role in stockmarkets of active managers — and of humans generally.

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Money is gushing out of active and into passive. Marks noted that manager Vanguard launched the first passive investment fund in 1974 with US$11 million under management.

By 1999 it grew to US$100 billion. Now, it's over US$400b. He also noted passive funds were 42 per cent of all stock fund assets in the US — up from 12 per cent in 2000.

Other investors program computers, using quantitative rules and algorithms, to copy most of what active managers do, often at less cost and always without emotion and the errors that go with it.

Or the computer is the investor. The AIEQ ETF in the United States uses IBM's Watson Artificial Intelligence (which beat humans playing the Jeopardy quiz game show) to analyse US companies.

Starting in October 2017 it trailed its S&P500 benchmark. But with Watson doing the number-crunching work of 1000 research analysts around the clock, it caught up and at June 25 had returned 13.41 per cent versus 6.9 per cent for the S&P500, since inception. Less than a year is nothing in investing, of course, and Watson hasn't been tested with a big market downturn.

But it's ominous (and AIEQ costs 0.75 per cent, with no performance fee).

Unfortunately, active managers must blame themselves. Passive investing was invented because most fund managers couldn't beat the market, certainly not after fees. Now it's even harder for fund managers to outperform. Worse, their struggle is far more visible.

Readers will be familiar with Warren Buffet's US$1m bet that the S&P500 index would beat a handpicked group of hedge funds over 10 years.

Buffet won comfortably — the S&P500 returned a US$854,000 profit against US$220,000 from the hedge funds (the hedge fund executive who took the bet gave up seven months early).

So, if most people can't beat the market because they're not good enough, they charge too much (or both), why shed any tears? It's just market Darwinism. Marks didn't try to pretend otherwise.

And yet, the market needs active managers like a jungle ecosystem needs predators — regardless of performance or fees.

Active managers value companies and buy or sell them accordingly. This is how companies are priced, which determines their presence and weighting in the indexes used by passive investors, and supplies the data and information signals used by computers.

"Non-human" investing methods also have their risks. Marks notes most passive investing directs (very) large amounts of money into companies based on size, not merit.

As more money flows in, prices of the largest companies become more inflated, and what happens in a large market retreat?

It's not been tested and is relevant given the jittery markets presently. Passive selling in the same volumes and concentrated in the same names is unlikely to be pretty.

Especially if, as might happen with ETFs, it takes longer than expected to sell out.

Plus, computer rules and formulas cannot be successful in all markets. If they were, computers would figure it out and the successful would become the average.

It's in everyone's interest that active managers don't become extinct.

No-one's gifting them protected status, however. Active managers sink or swim on attracting clients and money.

The best way is beating the market. As we've said, this is hard and takes genuine, repeatable skill. Some investment managers have it (although for their clients the benefits may disappear after fees); most don't.

So, it's probably easier to reduce fees so clients see more of the return and stick around.
Marks hints that for genuinely skilled managers, market Darwinism is useful.

Fake or bad active managers are forced out of the market, or made to emerge from the index-hugger closet, embrace passivism and charge less. Either way, the active management competitive field improves.

Plus, with more passive investment — and, until a big correction, there's lot of growth to go — hunting improves for active managers. When fewer players set prices, markets become less efficient (meaning, there is weaker — or no — consensus about what a company is worth). And active managers love an inefficient market.

To survive in the jungle, active managers must sharpen their skills or their prices. Ideally, they should do both.

Mike Taylor is chief executive of Pie Funds