Is it time to move on from active management?

No - Chris Bailey

At the beginning of 2017, a respected investment flow survey observed that the ratio between passive and active investments had reached a record of nearly 50:1, in favour of the former. This continued a big trend, with passives 12 per cent of total European mutual fund AuM by the end of last year, according to Thomson Reuters Lipper, compared to 5 per cent in 2004.

But scrape below the headlines in areas such as US and UK  equities and you find that passive funds saw inflows while their active peers saw outflows. In short, investors appear to believe these markets in particular are not inefficient enough to warrant the costs and benchmark variable performance of an active approach. 

The origins of this trend go back to the depths of the global financial crisis, which induced multiple global central banks to take their first steps into unorthodox policies like quantitative easing and very low interest rates. 

These policies benefited broadly all risk assets. Correlations between individual stocks fell and scope for active management abated. Fees and growing preponderance of passive and ETF solutions made this shift in flow start to become even more sensible. 

However, investment markets do not stand still. At a time when the US has started to push up interest rates and move away from the policies of exceptional central bank stimulus, stock correlations have once again started to fall. Early data for 2017 shows almost half of actively managed large-cap US equity mutual funds managed to beat their benchmarks in the first two months of this year.

All of this has left investors in a quandary. Simply put, if you believe central banks are moving away from economic stimulus, active investment selections seem on average a more attractive prospect to beat their passive equivalents. Factor in Brexit, eurozone political angst and sharp debates over the success (or not) of economic change plans in key Asian countries like China and Japan, and it is tempting to favour a more active asset allocation approach than has been seen recently.  

Index tracking passive solutions typically buy momentum and sell price weakness. A predominantly passive approach could therefore undermine one of the key rationales for the stockmarket: to allocate capital in a manner which rewards return-generating behaviour. It is possible smaller companies  will not attract passive flows of capital until they reach a certain size. Having passive capital trapped in the largest companies by dint of their size, rather than investment potential, is not good for the dynamism of the broader economy.

Fees provide a high hurdle for active managers to jump over, but a central tenet of a successful portfolio is diversification. Adopting a completely passive approach may minimise short-term fees but leaves the allocator exposed to change in areas such as individual stock correlation and central bank stimulus, as well as shifts to a more value or mid/small cap preference. 

Collectively this has the clear potential to hurt performance versus a benchmark. 

Yes - Alan Miller

As a fund manager for some 28 years, having managed active funds including the first UK equities hedge fund that returned 17 per cent plus annually over nine and a half years, I am often criticised for extolling the virtues of passive funds. 

The reality is that my dissertation at university back in 1985 was on active versus passive portfolio management.  I interrogated the academic evidence and concluded there were anomalies in smaller company shares, but elsewhere passive made more sense. This resulted in a fund management career trying to find smaller company nuggets.

But that was then, and this is now.  Only a fool walks without seeing how the landscape changes.  In the low return environment, where information is freely available to all, the reality is that active management is no better than buying a lottery ticket.   

There is nothing wrong in buying a lottery ticket – if you know the odds are against you winning.  Active management is the same except the company flogging the tickets tells everyone they are going to win when they are almost certainly not. 

So why does passive investing make more sense? 

Cost: According to the recent Asset Management Study from the UK’s Financial Conduct Authority (FCA) it cost nearly three times the amount to invest via an average active vs passive fund (1.175 per cent vs 0.402 per cent).

Performance: Outside the amateurish efforts of the conflicted Investment Association research, there is very genuine evidence to support passive management. 

As the FCA points out: “As long as average active charges and transaction costs exceed the charges and transaction costs of tracking the market benchmark (investing passively), more active money would underperform the market benchmark (and passively-invested money) after charges than outperform it.” 

Professor David Blake from Cass Business School tested two active managers’ scenarios to test levels of skill when it came to producing outperformance. He found 95 per cent of managers were unable to outperform, net of fees, and in the second model almost none had the ability of outperformance. 

Consistency: The latest S&P research suggests the longer you invest via an active fund, the greater the chance of losing vs the benchmark, even in emerging markets.

Transparency: If you invest in an index fund you know what you are investing in 100 per cent.  In an active fund, you are typically told just the top 10 holdings, which often represent less than half the fund.

Information Edge: Active managers used to have an information edge by getting information first.  Today, information is regulatorily required to be disseminated across the market, and to all stakeholders, often at no cost; eliminating the edge.

To sum up, this is the advice of the greatest living investor, Warren Buffet when investing his own legacy:

“My advice to the trustee couldn’t be more simple: Put 10 per cent of the cash in short-term government bonds and 90% per cent in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.”