The RDR seems to have fired the starting pistol on the race for passive – new ETFs are launched almost daily.
At first glance the evidence for passive appears compelling, with few active managers outperforming their respective indices on a consistent basis. There is a raft of academic work that shows active just cannot beat index investing ‘on average’.
There is a growing advocacy in the UK adviser market for passive, and they are not alone. In the US funds market Vanguard recently overtook Fidelity for the number onespot in the funds rating with $1.3trn – a place that Fidelity has held for over 20 years.
But Vanguard is not just a passive manager – around 50% of its global assets are active – it is a low cost manager.
The accidental active manager
However there is, without doubt, evidence that some active managers add value – recent M&G analysis showed the top 10 active funds in the IMA UK All Companies sector over the past 10 years hugely outperformed the FTSE All-Share Index, returning 117.7% on average compared with just 26.9% from the index.
This is evidence the market is inefficient and that it misprices companies, says M&G and the theory is compelling. Concentrated indices can sometimes lead to heavy losses, such as those from the banks that weighed heavily in the FTSE 100 Index during 2008.
Unlike passive funds, actively managed funds are not tied to stock or sector weightings determined by an index. The manager can make investment decisions on companies and sectors seeking the best valuation opportunities.
Active managers have the flexibility to quickly react to changing market conditions and, for example, move out of poorly performing companies to preserve value during falling markets.They can also be forward looking – to decide which are the key themes and structural shifts in economies or consumer behaviour that have major investment potential.
Many of these points are just as relevant for passive fund users as they are for active managers. Selecting the right index to track is just as important – which is the right index for my exposure for the passive advocate and what is the appropriate benchmark for the active manager?
Deciding the right strategic asset or sector positions in a portfolio or fund is crucial to the long-term returns of active or passive mandates.And tactical asset allocation can be effective for active or passive portfolios.
Even at the underlying securities level – where the active manager selects stocks – due diligence of the type of replication, the levels of securities lending and quality of counterparty and collateral require an assessment of the relative risk and return trade-offs are required before using passive funds/ETFs.
A problem with the definition?
In each of the core three steps of multi-asset portfolio construction – strategic allocation, tactical allocation and stock/fund selection – a decision over active or passive approach is required.
A completely passive strategic asset allocation is unusual – that would require slavish following of some mathematically derived benchmark – and while mean variance optimisation (MVO) analysis can be useful it nearly always requires some assumptions to be overlaid. This seems sound for, as Professor Andrew Clare of Cass Business School so eloquently described one of the key risks with optimisers, “Garbage in is garbage out”.
Tax changes, exchange controls, structural political/economic changes would surely require adjustments in this strategic view – no matter how long term your perspective.
Tactical asset allocation – even for passive advocates – usually has some form of active element. Within target risk funds or target dates funds asset decision are being made – whether these are mechanical or human – they are still active. A value or contrarian overlay is common within passive portfolios – tilting away from overvalued sectors/assets for example. I doubt that over any reasonable time period there are many absolutely pure active or passive managers.
Is active doomed?
There is a move to passive funds here in the UK and in the US. Today in the UK retail funds market about 5% of total assets are managed on a passive basis compared to around 25% of institutional assets – so there is still a long way to go.
There are still many active decisions that need to be taken. Supposing you want exposure to UK small cap; do you really want to buy all the investments trusts in the index that actually have exposure to large cap stocks underneath?
When seeking property exposure, is the FTSE REIT index (of quoted property stocks) an equity index or a property index?
Think about a bond index for a moment – is having the largest exposure to the company with the most debt a sensible way to allocate to the asset class? Most investors’ real long term risk is inflation and how do you accurately track that?
Use the strengths of passive within active
One of the core strengths of passive is its low cost – both total expense ratio trading costs created by lower turnover. Recent Morningstar analysis in the US of the predicative power of different factors of future performance noted that in every single time period and data point tested, low cost funds beat high cost funds.
Whatever your stance on active or passive a key factor in any fund/manager selection process must surely be the total costs of the manager. This applies to all forms of fund management – the trading, stock and custody fees in model portfolio and discretionary management can really add up and destroy any alpha the manager may be able to deliver.
It is also critical to make sure the index/benchmark being selected is sensible – is it a total return index (including dividends etc)? What is its stock or asset weighting? Is the benchmark appropriate? Were the ten M&G outperformers benchmarked against the FTSE All Share? Or were they small cap, or FTSE 100 benchmarked? It makes a big difference.
There are opportunities to combine active and passive techniques. The construction of screened small-cap portfolio coupled with low cost trading techniques has created a considerable following for the Dimensional Fund Advisors range, for example.
The growth of interest in ‘passive with a twist’ is evidenced by the huge interest in the In Capital structured products roadshows. One might argue these funds are passive or have beta exposure with a derivative structure to modify the return profile. Is that active or passive?
There is surely a role for these products as more and more clients move from accumulation to de-accumulation of their pension funds.
A low-cost passive core with active satellites is a very common strategy for institutional pension funds. It is low cost, tailored to meet schemes objectives/risk profiles, and can have income or growth overlays – the application for retail client portfolios is clear.
Low-cost funds are likely to be the best home for most investors’ long term assets – but it is clear that advisers do need to take active decisions to get the most of these low cost solutions – passive or active.
There is one ‘accidental’ active manager who many of us surely are hoping has that elusive alpha. Alistair Darling probably took one of the biggest ever sector bets in UK fund management history in 2008 when he took huge stakes in the banks. Whatever the drivers of that ‘active decision’ I really do hope it turns out well.
David Norman is joint founder & CEO of TCF Investments
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