Join our community of smart investors

The Active vs Passive debate continues...

THE BIG THEME: As the old investment debate rages on, many argue that the time has come for the two investment approaches to meet in a core satellite investment approach.
April 3, 2009

Bankers were not the only ones abandoning their business attire for trainers and hoodies last week. As animosity around exorbitant remuneration packages and poor investment decisions grow, fund managers are also being placed on the watchlist. As Joe Public becomes increasingly fed up with those making money out of money, the need to add value and ensure investment growth has become pivotal and consequently the debate around active versus passive investing is raising some interesting arguments.

Survivorship bias

Passive investment, or index investment management, is designed to track the market rather than beat it. In contrast, active management seeks, through the application of judicious stock selection and/or asset allocation, to outperform the index and add value.

As Robert Davies, managing director of Fundamental Tracker Investment Management, points out, combined together, all funds can only deliver the return of the market. "Thus as a group, passive funds will deliver the same gross return as active funds, but active funds suffer the drag of higher fees, higher turnover and hence higher costs. Consequently, they have to deliver higher gross returns and this is done by taking more risk."

However, despite taking more risk in their investment approach, a number of studies have shown that over time active fund managers tend to underperform their benchmark.

In February, Investors Chronicle ran an article citing findings from funds of funds manager T Bailey. The research, which compared the performance of actively managed funds benchmarked by the FTSE All-Share Index and passively managed funds that track it, seemed to swing the performance pendulum in favour of actively managed funds. The findings certainly raised eyebrows, with advocates of the passive investment approach questioning the basis of the research.

Alan Dick, a certified financial planner at Forty Two Wealth Management, says T Bailey’s findings compare the average actively managed fund to the average tracker. However, given that the differences in tracker performance are largely down to costs rather than manager skill, a rational investor would be expected to pick a low cost tracker and not the average. "On the other hand investors pick active funds based on the hope of outperformance, irrespective of charges, so using an average for active funds for comparison would be appropriate. If you compare a low cost tracker like the L&G UK Index Fund to the average active fund, the tracker wins in most cases," says Mr Dick.

The fact that the research fell prey to 'survivorship bias', showing the returns from only the surviving active funds over the period analysed, also raises questions.

"There is a substantial body of academic research into survivorship bias which suggests that it overstates the performance of the sector average by between 1 per cent and 2 per cent per year," says Mr Dick. Such 'overstating' can be compounded to overstate cumulative returns by as much as 45 per cent over 20 years.

When a fund closes, its entire performance history disappears from record, which can understandably skew the figures. Poor performing funds are closed down all the time and asset managers often use the tactic of merging a feeble fund with a more successful performer in order to improve returns. Mr Dick cites Schroders as an example. The asset manager recently closed its poor performing UK Select Growth Fund and merged it into the much more attractive UK Equity Fund. "Compare the data for the old fund and the new fund and you will see how investors are having the wool pulled over their eyes," he says. Unfortunately such comparisons are virtually impossible because dissolved funds are wiped from investment databases.

Just prior to the bursting of the tech bubble, Gartmore launched an internet fund called the UK Techtornado Fund. "Investors lost around 70 per cent of their money almost overnight," says Mr Dick. But don't try and search for the fund on any of the data providers, because you won't find it. It was merged with the Gartmore UK & Irish Smaller Companies Fund and has enjoyed substantial growth since then.

At the beginning of 2008 the poor performing New Star Special Situations Fund was merged with the UK Alpha Fund. "All mention of the UK Special Situations fund has since been erased from the records and the woeful performance has been replaced by the better UK Alpha Fund which has beaten the sector average by around 2 per cent a year since launch in November 2001," says Mr Dick.

Investor psychology

While 'survivorship bias' certainly skews performance figures, investment behaviour also dictates the returns captured by investors. Most market participants tend to buy an active fund after it has enjoyed a period of strong performance, which means that they can end up underperforming the average fund, the index and in many cases even cash.

Andrew Wilson, head of investment at Towry Law wealth advisers, cites the ABN Amro UK Growth fund, as a good example. "Run by Nigel Thomas in the late 1990s the fund built up a great track record specialising in mid cap growth stocks, especially technology names. By the time Mr Thomas left for Artemis the fund had rolled over as tech blew up, but his long term track record still showed outperformance. However the vast majority of his investors had come into the fund in his last year and hence suffered a dispiriting experience."

A study conducted by Lukas Schneider of Dimensional Fund Advisors shows the impact investor behaviour and fund manager actions have on investment returns in the UK. Covering the period between 1992 and 2003, during which the FTSE All-Share Index returned 8.99 per cent, Mr Schneider found that the average UK equity fund returned 6.95 per cent due to manager decisions and the impact of charges. The average investor only managed a return of 4.91 per cent. This 'performance gap' is largely attributed to investors mistiming the market - piling into so-called 'hot funds', after they have enjoyed a period of good performance.

The study also breaks down the figures into individual fund groups to establish where the performance gap is greatest. Investors in Fidelity funds lagged the quoted performance of the group's funds by an average of 3.66 per cent per year, while Jupiter investors suffered a performance gap of 5.8 per cent.

Instead of chasing the fund flavours of the month, investors need to alter the way they monitor investment returns and it is here where calculating the 'money-weighted return' becomes crucial. This figure measures the rate of return relative to the length of time that the capital has been invested, showing investors what they actually got from their money.

"The money weighted return focuses on when money is invested and withdrawn and therefore shows the fuller picture. This is different to time weighted returns which simply calculate the difference in fund value between the start and end of a period without weighting money flows," explains James Norton, director of Evolve Financial Planning.

In defence of Active investing

The inherent challenges to getting one's timing and fund manager selection right certainly make a strong argument for passive investing. However, many believe there is still more merit in buying an actively managed fund - especially in the current market.

Meera Patel, analyst at Hargreaves Lansdown, says that while tracker funds may look appealing during a rising market, this is not the case in markets that are falling or moving sideways.

She says that tracker funds that charge 1 per cent are a "rip off" and there are several in the market including the Virgin tracker, which charges investors a fee of 1 per cent a year. Charges of less than 0.5 per cent can be considered more reasonable for a tracker, considering that there is no stockpicking involved and high charges simply eat away at performance.

But what about the charges attached to active management? Ms Patel says investors should not be too worried by active management charges unless they are performance fees. "Generally speaking if a manager delivers consistent outperformance, I believe it can be worth paying a bit more for superior returns than for a tracker."

Ms Patel also does not share the view that passive investing is a more risk-averse approach. "The trouble with trackers is that the majority will hold all or most of the stocks in their respective indices, even if there are valid reasons not to hold certain stocks. This can actually make trackers more volatile," she says. "Active fund managers will generally aim to hold the stocks that are likely to make money and are not compelled to own stocks with poor prospects."

Ms Patel's view is that the UK is entering a golden age of active investment, but says that there are only a few managers you can back, adding that managers who are not benchmark-orientated are the ones likely to make the most money for investors.

Meeting in the middle

Tim Cockerill, head of research at IFA Rowan & Co Capital Management, makes the point that in some regards, the passive investment approach has been turned upside down for the moment.

"A fund that is benchmarked will rarely move too far away from benchmark weightings for fear of underperforming and typically this type of approach would be deemed to be lower risk. However, at times when preservation of capital has been important, this approach has failed investors and funds with a perceived higher risk have been better able to preserve value. An example is the Neptune US Opportunities Fund, which is conviction based and actively managed, with no benchmark constraints, giving it the freedom to invest where opportunities exist."

Mick Gilligan, head of investment research at stockbroker Killik and Co, thinks that, in the current market conditions, active management is better placed than passive management over any reasonable time frame. "The evaporation in liquidity means that a number of mid sized and smaller stocks are trading at valuations that reflect their tradable volume but belie their ability to generate future earnings. These stocks will be 'de-emphasised' in a passive approach whereas an active manager can overweight them. We think this will be a fertile hunting ground for active managers, not in the short term, but over the next three to five years."

Consequently, a number of investors are embracing a core satellite approach where active and passive investment strategies coexist within a portfolio. Tony Foulkes, financial planner at London-based IFA Jonathan Fry & Co, says his firm favours a combination of active and passive management. "The tracker, or increasingly, Exchange Traded Funds (ETFs), if used as a core investment, gives an investor low cost access to the equity market and exposure to large cap companies. Satellite holdings can then be introduced to cater for specialist needs, such as international markets, smaller companies and specialist plays. These would be served by active managers who know their specialism and can pick stocks based on their potential."

Combining the two, says Mr Foulkes, gives a broad investment exposure, while keeping charges to a reasonable level.

Mr Cockerill agrees that the core satellite approach works, but not in the sense of 'core equals tracker'. He says the core should embrace an active investment style that is risk averse or even benchmark aware, with tracker satellite investments giving exposure to specialist or higher risk strategies.