Don’t worry, I’m certainly not going to join the voices exhorting you to use this new lockdown to try Couch to 5K or some other ambition fitness goal. What I’m actually referring to is one of the investment industry’s most long-running debates: whether active or passive investing generates better results.
To briefly recap definitions, with active funds the intention is to outperform indices like the FTSE 100 by having human beings spot investment opportunities through extensive research. Passive funds, meanwhile, only intend to match performance through the automated buying (and rebalancing) of a basket of stocks which replicate a benchmark.
On the surface, there would seem to be no debate at all: active equals alpha, surely? Yet digging deeper reveals far more complexity for investors to navigate.
At the heart of this issue are investment costs. As we always preach, performance has to be looked at net of fees. Having teams of people diligently researching markets and securities means active funds typically have far higher expenses than passively managed ones run by computers. The management fees for passive equity mutual funds tend to cost a tenth of those for active ones, for instance. This difference between, say, 1% and 0.10%, can completely negate any outperformance active management achieves – to the point which the vast majority of active funds do not beat their benchmark.
Many factors to weigh
This knowledge has resulted in a massive shift towards passive investing in recent years, but still not a complete one. Why?
First is that you simply couldn’t have stock markets operating completely passively since price moves are driven by the risk-reward calls which active actors make.
Second, tracking a benchmark to match its growth only works if valuations are in fact growing. As the events of 2020 have painfully reinforced, that is certainly not always the case. Advocates of active would say that volatile times are their chance to shine and these have been bumpy in the extreme. Some active managers certainly have done well by reacting swiftly to trends and specific events during these strangest of times.
Some yes, but definitely not all. Active management has not had the renaissance that logic might have foretold. Whether managers did indeed have the talent to read the runes will have of course been a key determinant of success. Yet another just as important factor is at play.
When weighing up active versus passive, we must always remember what a particular fund is focused on and whether that market is efficient in reflecting changes in investor sentiment. The more it is, the harder it is to seek undervalued assets because information is rapidly priced in. In less transparent and well-researched markets, the opposite may be true, handing talented managers the opportunity to seek genuine alpha.
Context is all
For this reason, I always take declarations about “the death of active management” with a pinch of salt. The figures cited in this debate (or at least the ones cited in the mainstream media) tend to look at the leading large-cap equity indices which are among the most pored-over and therefore efficient in the world. Things often look very different elsewhere: although only 22% of active managers have outperformed the S&P 500 over the past five years, this is more than double in the case of South Africa’s DSW Capped Index, at 46%.
So, while it may be true that active managers have generally underperformed their passive brethren in the foremost equity markets for years, that assertion can’t be made universally for all markets – nor for all asset classes. Depending on the context, there may still be plenty of room for active managers to deliver real value.
As with so many supposedly black and white questions, the one of active versus passive in fact places us in a very grey area. This is just as it should be, I would say.
The right answer depends on a host of factors, only some of which I’ve addressed here. These will be unique to the investor, their situation and other holdings, alongside the market conditions at that time. Cheaper might not always be better, but likewise higher fees don’t necessarily equate to higher returns.
These are questions for careful debate and I hope to have given readers some serious food for thought about how active or passive their portfolio should be. As for how active we ourselves should currently be, I know which side I’m on…