Slaying the active passive myth

There are two strands to active portfolio management: asset allocation and security selection. To stick with the nautical analogy, once you’ve chosen your destination, tactical asset allocation is like managing the route – there will be times when there is a tail wind behind equity markets or a prevailing current favouring bonds and you modify course accordingly. Our focus here, however, is on more granular decisions – the choice of funds and, for self-directed investors, stockpicking. Whether investors crew their own portfolio, or decide they like the cut of various fund managers’ jibs, the central question remains: Is it possible to beat the market? 

The QE years have seen investors achieve outstanding returns from equities simply by buying the market. Thanks to the mass proliferation of cheap exchange traded funds (ETFs), this tactic has become more accessible and cost-effective, casting doubt over the worth of stockpicking and especially active managers. Why pay someone to underperform or take fees out of returns the market was offering anyway? The past decade, however, has been exceptional and, as monetary policy is slowly normalised, the effect of QE in obfuscating the relative merits of active and passive investing will subside.

The argument for coasting on the wind and the tide

Long before the US Federal Reserve was pumping liquidity into the financial system with its QE programme (2008-14), there was plenty of research doubting the ability of American stockpickers to consistently beat the market. The efficient market hypothesis posits that in properly functioning markets, information is rapidly reflected in prices, so individual investors cannot maintain an advantage. In other words, mean reversion is incredibly powerful in stock returns. The famous assertion made by Burton K Malkiel in 1973 was that monkeys throwing darts at the financial pages of the Wall Street Journal wouldn’t underperform the experts. In a gimmick by that paper in the 1980s, fund managers did beat the monkeys (although Malkiel argued that their picks benefited from publicity), but only 51 per cent of stock picks beat the market. Advocates of passive investing seized on this, pointing out that once fees are considered, if investors can only pick winners slightly more than half the time, trackers will deliver superior net performance over the long term.

Charges undoubtedly can have a major drag on returns and years of opaque and, in some cases unscrupulous, fee structures have come home to roost for the asset management industry. The enforcement of Mifid II (the second iteration of the European markets in financial instruments directive) is a game-changer and the emphasis on fee transparency brings the question of value-added sharply into focus. The ease of creating multi-asset portfolios with ETFs has enabled a new breed of so-called robo-advisers to emerge. Producing risk-banded model portfolios with minimal fund charges, these companies can make a decent margin on solutions that are still cheaper for retail clients than those offered by traditional asset managers. 

The marketing of passive portfolio solutions and a regulatory zeitgeist that (justifiably) is focused on costs and transparency has contributed to the narrative that active investment isn’t good value for money. Coupled with the adverse publicity generated by famous fund managers such as Neil Woodford suffering bad recent years, investors have been encouraged to move from active to passive funds. Growth has been spectacular, with ETFGI Consulting reporting that assets invested in ETFs and exchange traded products (ETPs) globally breached the $5 trillion mark at the end of May 2018, the 52nd consecutive month of net inflows.

Making the case for active

In a sustained bull market, it is easy to focus just on cost and total returns – when benchmarks are going up and it’s cheap and easy to invest in them, where’s the incentive to pay higher fees and add the risk of a manager’s more concentrated approach? The information ratio is a tool for assessing how the deviation managers make from benchmarks, or ‘tracking error’, adds value. The higher the information ratio, the better the manager has performed, and past exercises ranking UK mutual funds on this measure have shown that targeting most geographies, the best active funds – even in the recent years of exceptional monetary policy – have generated excess returns versus benchmarks.

In a March 2017 presentation to delegates from the Chartered Institute of Securities and Investment (CISI), Jonathan Gumpel of Brooks MacDonald showed empirical evidence in support of active fund management. Using information ratio figures extracted from FE Analytics, Mr Gumpel found it was only among funds focused on North American equities where active funds struggled to outperform trackers over one-, three- and five-year periods. For UK, Japanese, European and emerging market equity funds, a significant number of active funds had positive information ratios, especially over three and five years.

Repeating the investigation of FE Analytics data for mutual funds in June 2018, of 260 mutual funds targeting the UK stock market in the IA UK All Companies TR list, 135 active funds had positive information ratios. Passive funds should in most instances have little tracking error to their benchmark, but after costs 16 out of 27 passive funds had negative information ratios. This doesn’t mean passives aren’t good value for money – they have to charge something and the costs are generally lower – but it does show that there are many active managers who do add value after fees.

Active adds value

This brief survey highlights important facts about both passive and active mutual funds. Firstly, if most active managers have positive information ratios, the worst must have done very badly. Sometimes this can be explained, especially over just one year, by the cyclical nature of a manager’s investing style. That said, glancing up and down the list, there seems to be no discernible pattern between funds labelled ‘growth’, ‘dynamic’ or ‘value’ outperforming. This suggests a combination of misleading marketing of funds and a lack of style discipline by managers. The obvious conclusion is that there are simply good and bad managers. 

Neither are passive funds created equal, with variation in their information ratios. As these results were based on performance net of fees, differences in cost is a factor. Also, the size and liquidity of the index tracked and the type of replication – whether the fund bought all the stocks in the index or selected a sample – would have a bearing on tracking error and returns.

The one thing that cannot be said, both from our quick glance at UK equity funds and Mr Gumpel’s more comprehensive study a year ago, is that all active funds have been poor value for money. Such accusations clearly rankle with Mr. Gumpel, he says: “Extraordinary, isn’t it, that pretty much everything people have been told/understood of the active versus passive/tracker debate is wrong and that the US-led tracker industry/lobby has managed to pull the wool over so many people’s eyes and so many industry thinkers and journalists have just accepted it?”

Where passive is best

Low charges don’t necessarily mean better net performance by passive funds, but cost is clearly a factor. For example, the Vanguard FTSE 100 unit trust tracks the index with an ongoing charge of just six basis points (six basis points is six hundredths of 1 per cent). The fund has only been live since 2016 but looking at recent FE data, as of June 2018, it has performed well over one year. The data we looked at was focused on mutual funds but, given FTSE 100 ETFs charge similar low fees (iShares FTSE 100 UCITS ETF, ISF, charges seven basis points and has tracking error of just 1 per cent), the best ETFs would have above-average information ratios where the index they track has done well.

Low fees and minimal tracking error are strong arguments for using ETFs and they are a cost-effective option for gaining exposure to whole markets. The 2017 research carried out by Mr Gumpel concedes this would have been a good way to invest in North American equities over five, three and one year horizons. Most of the research in support of the efficient market hypothesis has been focused on the US and the weight of empirical evidence suggests trackers deliver good returns more consistently from the world’s largest stock market.

This has certainly been the case in the QE years, when US mega caps have attracted vast inflows of capital. The Federal Reserve’s $4.5 trillion asset buying programme and rock-bottom interest rates saw US Treasury yields fall to record lows. This in turn lowered the forward rate of return needed to imply an attractive risk premium for equities. Investors were therefore prepared to pay higher multiples for solid income stocks (especially as new bond issues offered ever smaller coupons) and for quality growth stocks without generous dividends, such as tech giants Apple (US:AAPL), Amazon (US:AMZN) and the holding company created for Google, Alphabet (US:GOOG). The combined weighting of ‘big tech’ and some of America’s biggest defensive stalwarts such as Walmart (US:WMT), Johnson & Johnson (US:JNJ) and Pfizer (US:PFE) has made it very difficult for active managers investing in S&P 500 stocks to beat the index, when these behemoths’ stock prices have risen.

Since the Fed ended QE, some money from overseas investors, buoyed by other central banks’ asset purchase programmes, has found its way into US equities. Low (albeit now rising) interest rates and a recovery in American corporate profits have also helped maintain the bull market. Growth investing has continued to outperform value as a style since the financial crisis and, in the US, it is the least volatile of large stocks that have done best. Analysis by London Business School (LBS) trio Dimson, Marsh and Staunton in the Credit Suisse Global Investment Yearbook 2018, calculates the average annualised return premium for low volatility US stocks between 2008 and 2017 as 6.2 per cent. Value investing by contrast has, on average, lost 2.9 per cent per year.

Value has also done badly in the UK, losing on average 2.6 per cent a year from 2008-17, but the reasons why an investor might choose a passive core holding here differ. The most effective return factor in the UK over the period has been momentum – whereby shares that have risen most in price continue to do well in the subsequent period. The LBS team estimates momentum returns (2008-17) at 13.5 per cent a year for the UK stock market. 

Momentum stockpicking strategies are near impossible to follow thanks to the level of turnover and the faith and discipline required to persevere with the system. Some smart beta momentum ETFs now exist but these are relatively expensive thanks to high trading costs, and will seriously underperform when momentum periodically fails, so aren’t suitable as a core holding.  

Active managers will, of course, hold some stocks with positive momentum but slowness to change their opinion quickly (anchoring bias) and staying disciplined to their style can cost upside. Another piece of analysis by Dimson, Marsh and Staunton in the Yearbook shows that the difference between momentum winners and losers among the largest 100 UK shares is worth the equivalent of 10.3 per cent, on average, per year looking at long-run data between 1900 and 2017. The study weighted companies by market capitalisation and the effect would be even greater if the index was equal weighted. Momentum may be the most ephemeral of factors but holding a tracker is insurance against losing out entirely when a manager doesn’t hold the latest big winners.  

Recent work by Victoria Dabrynskaya (2014 and 2017) has suggested fund managers are reticent about buying on momentum because they are worried stocks with expanding valuation multiples will have a lower forward rate of return and do worse than the benchmark. This gives rise to the paradox of managers missing out on a powerful return factor and some may even underperform their benchmark, precisely out of the fear of doing so.

Rising dispersion is good for active managers

Thanks to cheap costs and their ability to partially capture factor returns that sometimes completely elude fund managers, market-cap weighted ETFs make a good core holding. Fund data research shows, however, that – even amid favourable conditions for passive funds – the very best performers are overwhelmingly active managers.

As central banks begin to retreat from loose monetary policy, conditions will be ripe for active managers to outperform benchmarks. Dispersion in stock markets can refer to volatility, which is the standard deviation of returns, or the range of betas (a measure of an individual stock price’s co-movement with the direction of the market, showing its sensitivity to market risk) of stocks in the market. The greater the level of dispersion, the more opportunity there is to pick individual stocks that will beat their benchmark.

With monetary stimulus being scaled back or reversed, depending on which region you look at, there will be less liquidity in financial markets than there has been over the past few years. As capital becomes scarcer, patterns in its allocation change. Fundamental factors such as companies’ exposure to GDP growth, ability to generate cash from operations, working capital cycles and the strength of balance sheets will be considered more carefully and have greater effect in determining share price performance. The UK is traditionally a stockpickers’ market and with GDP growth slowing but not yet stalling, there could be attractive opportunities.

Lower levels of dispersion in the recent past has suited passive investing as it meant that, in an environment when the market has been positive about taking risk, there was a free ride of beta gains to be captured. One argument that has frequently been made, especially in relation to the US market, is that passive investing creates its own momentum. Large inflows via passive vehicles are allocated to the market and companies with the highest market capitalisation weights receive the highest inflows and therefore the biggest just get bigger.

While this may be true in terms of expanding market capitalisation, there is no distorting effect on index weightings. What it does mean, though, is that lower dispersion between companies and sectors has been perpetuated as ‘buying the market’ and means there is less judgement being made as to the changing merits of companies. What could be very interesting for managers of US equity funds is if several companies in a huge sector such as tech were to start disappointing on earnings. If this encouraged selling of market trackers, then share prices of smaller companies would be affected, too. If these businesses were performing well then value opportunities may return, which would increase dispersion and favour active fund management. Up until now, though, generally impressive earnings growth and an overall pattern of forecast beats by some of the big US tech companies has prevented such an outbreak of nerves.

In other asset classes

Balanced portfolios don’t just include equities and there are several instances where paying for an active manager represents value for money. In fixed income, for example, accessing lower-risk short duration quality government bonds might as well be done using an ETF. For more complex investments, such as higher duration (more sensitive to interest rate changes) bonds, high-yield bonds or emerging markets bonds, then the skill of an active manager in managing risks relating to credit, reinvestment, liquidity and duration is worth the fees.

For an asset such as property, which is illiquid and has such a myriad of potential variables affecting returns, it almost never makes sense to invest passively, unless the purpose is pure speculation on the direction of real estate prices. Conversely, for an asset such as commodity prices, where the investment is almost certain to be price speculation, then passive vehicles make the most sense.

In short, there really shouldn’t be an active versus passive debate – the best choice is to be agnostic. Passive vehicles have democratised access to a plethora of investment opportunities, but asset managers whose business model depends on passive products are being disingenuous in failing to recognise the breadth of quality active managers who demonstrably add value for investors. Charges will of course be a part of any decision – competition and scrutiny is beneficial in keeping fees fair – but active funds are often better value for money than they are given credit for.