Daily Equity Report
Seed Weekly - Passive vs Active Investment Management
The age old debate pitting passive vs active investment management has raged on for decades, proliferating recently. This comes as a result of the struggles that active managers have faced in trying to outperform index benchmarks, particularly over the last five years. The trend is common on a global scale as well as in a South African context.
The conflicting views, proponents of either strategy have, attempt to explain the benefits and drawbacks of both strategies. A critical point, and to the fore of the passive argument, is the fact that over time, active managers have been shown to be unable to consistently deliver “higher returns” than the index. Given that active managers charge a “higher fee” for their active management skill, failure to outperform the index over the long term questions whether the fee is justified – i.e. should we be allocating money to active managers?
As a multi-manager, allocating money to different strategies in our funds, it is important to get this call right so that our clients can fully benefit from having the right strategies within our funds. Critical to this is understanding the merits of either passive or active investing without putting emotion into it or being married to any of the styles. Our aim is to always pick the strategy that fits best from an overall portfolio perspective, allowing us to deliver on our mandate with our clients. Factors like cost, the ability to outperform, minimising risk and capital protection are central to our analysis.
The “Passive” Argument
The benefits of passive investments are well documented in literature. What is likely most appealing from these reports is the low cost and the ability of these strategies to outperform most active managers. The Lipper survey using data up to December 2012, showed only 20% of active managers outperform the MSCI World Index over 5 and 10 year periods. Figures from the South African S&P Indices Versus Active (SPIVA) scorecard suggest that active South African fund managers, like their global counterparts, fall short when it comes to beating the index over 1, 3 and 5 year periods. A recent survey by Morningstar concluded that the expense ratio is the best predictor of future performance and with passive funds generally charging lower fees, they are expected to outperform.
Low cost funds shown to have subsequent higher 5 year Total Returns as at 31 December 2015
Source: Morningstar Research
The “Active” Argument
Proponents of active management argue that superior skill that certain managers possess can lead to outperformance over an index. Central to this is the ability of a manager to use her skill to manage downside risk. Active managers can make informed investment decisions based on their experiences, insights, knowledge and ability to identify opportunities that can translate into superior performance. Historical data suggests that active managers do better in down markets than up markets. Generally, passive investments tend to do better in more bullish markets but fall a lot more when the markets are under pressure as they realise the full downside of the markets. Furthermore, it is argued that passively managed funds have no chance of beating the index but will always lag their benchmarks by the amount of expenses and cash drag. Data used to analyse active managers is also perceived to be biased by some underperforming ‘closet’ benchmark huggers, particularly on a net-of-fee basis. These kind of managers appear more passive than active.
At points in time, there is a good percentage of active managers outperforming the index. Data from 1980 using the US market.
Source: Seed Research using Morningstar Direct
Putting it all together
Focusing on a snapshot of data at a specific point in time potentially has the danger of reaching conclusions influenced by the most recent market conditions. A sustained period of bullish markets, as experienced over the past 5 years, strongly supports the passive argument as passive strategies generally do well in bull markets. Similarly, the strength of the more skilled active managers becomes more apparent when markets face downside pressure or are moderately up. In this case, good stock selection and risk management should help to protect active portfolios from the full downside of the markets. Successful active managers therefore require both skill and breadth (number of independent active decisions made in constructing a portfolio) to outperform.
There is a place for both passive and active management, especially if one has the ability to identify skilled managers. It is clear that if passive management delivers superior or at the very least similar returns to active management, at a lower cost, there is a compelling argument to simply go this route. Depending on an investor’s needs and constraints, time horizon and market conditions, a strategy of passive, active or a combination of the two may be appropriate. The market rewards different factors at different times and it is important to deal with the facts in this regard and not just a watered-down version of what was true at some point in time in the past.
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Wed, 18 May 2016- 08:35