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Debunking an age-old debate

Chris Boag

Chris Boag sheds new light on whether there is a clear winner when comparing active and passive investment management.

As equity markets around the world extend into an exceptionally long nine-year bull market, the debate around active versus passive investment rages louder than ever before. This is not a new debate, it is decades old and there is no shortage of commentary, opinion, white papers and expert views. But is this even the right debate to be having?

So, are you good enough at picking stocks to beat the market? Is your asset manager good enough? More and more people are choosing to simply invest and get a market return, shunning high-fee fund managers for low-cost passive or index managers. And why not? United States billionaire and world famous investor Warren Buffett thinks we should all stick with low-cost index funds.

But what is active and passive investing?

Active management

Active investing takes a more hands-on approach and requires that someone act in the role of portfolio manager. The goal is to beat the benchmark, such as the S&P ASX 200, average return and take full advantage of short-term price fluctuations. It involves analysis and research to know when to buy or sell an asset. Successful active investment management requires being right more often than not.

Active managers believe that because markets are inefficient, anomalies and irregularities can be exploited by those with skills and insight.

Passive management

Passive investing is investing for the long term. Passive investors limit the amount of buying and selling with their portfolios, helping to reduce costs. It’s a buy-and-hold mentality and is often associated with index funds that track major indices like the S&P ASX 200. Index managers don’t make decisions about which securities to own, they follow the methodology of constructing a portfolio that replicates the index it is aligned to.

Active v passive

Active investing is the dominant strategy, but this is changing. In the US, a little more than one-third of all assets are in passive funds, up from about one-fifth a decade ago. The shift is gathering pace too, with flows out of active funds into passive funds in the first half of 2017 reaching nearly $500 billion, according to Charles Stein’s article, “Active versus Passive Investing”, which appeared on Bloomberg on 6 July. The large index managers have been big winners and I am sure they will happily tell you that low-cost index investing is the way to go, how can you lose? In Australia, the trend is similar. The Australian Financial Review, on 28 April, reported that around 12 per cent of all funds under management in Australia were invested in index funds a decade ago. Now the number is almost double that with more than 20 per cent, in excess of $400 billion, invested in funds that track an index. The article added that if you look at the fund managers’ performance, it looks like a further 20 per cent to 30 per cent is in ‘closet’ index funds, where the fund manager is pretty much hugging the index.The trend is changing because research is showing that active managers are unable to consistently outperform the index. Buffett bet that over 10 years a portfolio of expensive hedge funds, run by Protégé, which took the bet, would underperform a low-cost index fund. He is likely to be emphatically proven right. Research will back him up as it seems high fees are a key determinant for underperformance.

Furthermore, active management has typically underperformed in bull markets and this has been particularly evident in the late 1990s to 2000s and in the current bull market that started in March 2009.

What the large index managers won’t tell you is the trend is cyclical. Active underperformed in the late 1990s/early 2000s as most didn’t or couldn’t understand the valuations of many dotcom companies, so held cash and did not participate in the extraordinary bull market that then crashed in spectacular fashion. Active managers outperformed passive/index managers over the following years. The same pattern occurred in the lead-up to the global financial crisis (GFC) and during the proceeding market crash. Active managers are underperforming now for similar valuation reasons. In fact, active versus passive investment approaches are as cyclical as value versus growth. Looking at the US, Morningstar produced data comparing the returns of active large-cap funds to S&P 500 Index funds (see Table 1). It’s swings and roundabouts, but active seems to underperform at times of market exuberance and outperform on the correction. So, over the long term, after fees, it seems the debate for active or passive investment is null and void.

Are index investors really passive?

I am not convinced index investors are truly passive investors. Let’s face it, unless you are buying a truly global index, you are making a distinct asset allocation decision that, in itself, is by definition an active decision. One can go even further by buying sector-specific indices such as property, which has been a common choice for a long time. Any financial planner using and recommending index funds is helping to make that asset allocation decision for you.

The rise of ETFs and market distortion

Many commentators have alleged the growth in index funds is creating a valuation distortion in the market. There is a further distortion of the market occurring at the present time and it is starting to raise more than just a few eyebrows. In a bull market where passive/index investing is outperforming, technology has come to the party to make it easier and cheaper for investors to take a piece of the action. This is achieved through the rise of exchange-traded funds (ETF). Moody’s Investors Service, in a press release on 2 February, noted the popularity of passive investments, including ETFs and index funds, will continue to outpace active investments and achieve a leading share of the US market by 2024, or sooner. Moody’s vice president and senior analyst Stephen Tu went on further to say “we believe that the passive phenomena is more appropriately viewed as the adoption of a new technology. Investor adoption of passive low-cost investment products will continue irrespective of market environments.”

Table 1: Returns of active large cap funds v S&P 500 Index funds

Source: Morningstar. Active large blend includes funds from the Morningstar large blend category that are not index or enhanced index funds. S&P500 Index funds are represented by the Morningstar S&P500 tracking category. Table constructed by Hartford Funds.

The ETF industry has attracted almost US$2.8 trillion in new business since the start of 2008, coinciding with one of the longest bull markets in US history, according to Chris Flood’s article in The Australian Financial Review on 15 August, “Record surge into ETFs fuels fears of stock price bubble”. According to the author, the record level of inflows into ETFs is fuelling fears that the tide of money is helping to inflate a bubble in the US stock market. Could it have just been all the cash that has been sitting on the sidelines for years needs to go somewhere? There is also the use of ‘big data’ to create many more trading strategies for ETFs. Investors were left disillusioned when the GFC hit and were left wondering what value active management really provided. A growing number of investors are moving into low-cost funds and ETFs that track an index probably in protest against active managers for inconsistent performance and high fees.

Think about this from an Australian perspective. Large-cap Australian Securities Exchange (ASX) index managers are likely directing 65 per cent of funds to the top 20 stocks and 40 per cent to the top eight stocks. The fear is that there is the potential for a liquidity squeeze in the event of a market correction or crash. In my August monthly update to clients, I noted a key risk to the global economy is that of the rising tension between the US and North Korea. As Gideon Rachman of the Financial Times said in his Australian Financial Review article, “Miscalculation could lead to a Korean war”, on 5 September: “These risks would be difficult to manage even with rational, experienced leaders in power. But the key decision makers are a 71-year-old businessman with a volcanic temper and no relevant experience, and a 33-year-old dictator, surrounded by frightened sycophants.” So this is a risk to the current bull market among other risks.

An ETF is listed on the ASX and its price will be determined by a number of factors and in theory will always trade at its reported net asset value adjusted for tax and dividends. The reality is an ETF can trade at either a premium or discount to valuation. In the event of a market correction or crash, an ETF will likely trade at a steep discount to valuation as investors run for the exits. The market maker will probably step in to ensure liquidity, but it won’t stem the flow. The market maker after all has to fund the purchase by selling the ETF assets. The concern is the untested potential for a liquidity crunch. If the market is falling and you are selling assets to fund the exit of investors, then who is buying the underlying shares? Well probably the underperforming high-fee active manager that is seeking to take advantage of the misallocation of price and the eventual normalisation of the market price for the assets.

Conclusion

So what is right for you as direct investor or as a professional advising clients?An index manager will buy everything in the reference index, the stocks that go up, the stocks that go down, the stocks that go bust, overvalued and undervalued companies, companies with good corporate governance and those that don’t meet your ethical screen. It doesn’t seem like a great strategy to me as it’s really an asset allocation decision based on your own investment goals and tolerance to investment risk. An active manager will actively buy and sell stock all day long to try and beat the market. They will buy a trend, a turnaround story, anything to beat the index, but as a fund manager gets bigger, they become more concerned about risk management. That is where any underperformance versus the index could lead to fund outflows, which is bad for business. An active manager then has to weigh up the risk of diverging too far from the index and thus becomes a ‘closet index hugger’.

So what does work? Buffett has told us all to go and buy index funds. Yet his portfolio of assets is nothing like an index fund. He, along with most wealthy investors, is a high-conviction investor and doesn’t just buy shares, he buys the whole company. The real driver of outperformance is your conviction to the investment thesis. When we go back to the active managers that have actually managed to outperform over longer periods of time, you will probably find them to be high-conviction managers with concentrated portfolios.

We believe in buying assets, not a strategy nor an index, that we can own for the foreseeable future and hold onto them, not trade them, but own them for as long our investment thesis remains intact. We believe in having a high-conviction portfolio where it is a competition for assets to gain a spot. By doing this we focus less on short-term market and stock movements and look to the medium to long-term potential. We believe this will lead to sustainable and consistent long-term portfolio performance you can rely on. We call this passive high-conviction investing.

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