Monday mashup – the everlasting active vs. passive debate

A refresher

Readers will likely know that investment funds are usually managed, either to own stocks in a specific country or industrial sector, or to manage a mix of assets (multi-asset). Investors pay fees, often quite high fees, because they think managers will apply skills to improve total returns and control risks.

Some years ago an American called John Bogle suggested that in the US fund managers actually delivered returns below that of their benchmark, say the S&P 500, most of the time. He then launched a business called Vanguard that offered investors a much cheaper way of investing by just buying an investment that more or less replicated the benchmark index.

There is more about this in detail in the article “Investing without management’ which can be found by searching using the key word “Passive”. This post is one for subscribers only.

There are other posts addressing the issue from different angles, including one of the first ones I ever wrote in March 2018, explaining how tracker funds tend to be more volatile

Recent Evidence

The research company Morningstar has reported on the relative performance of the average managed fund versus the average passive (tracker) for some years and recently released their European Active/Passive Barometer which looks at data over the last 10 years across all world markets. It is a 30 page document but one can pull some interesting data from the Executive Summary.

As might be expected, if investing in the main US markets, you might as well pick a low cost tracker because over 10 years only 5.6% of active Large Cap Blend funds survived (ie were available right through the period unchanged) and beat the average passive fund. 30% of small cap equity managed funds did better.

These sample extracts confirm something: fund managers can’t easily add value in markets that are extremely heavily researched and where any one can access all that they need to know about the market components. The more specialised and less researched a market is, the more chance there is for a manager to make money ahead of his benchmark.

It also follows that managers who are not benchmark aware might take very ‘active’ positions (ie go out on a limb) which will add ‘beta’, a separation from the market trend) for better or for worse. A good recent example of that was the Baillie Gifford group owning very large amounts of Tesla stock.

So it is no surprise that on a year to date basis the active funds that come out best are in areas like Korean Equity, Russian Equity, Austrian Equity and various others. One larger market segment where managers seem to do better is the UK mid cap classification.

The UK mid cap sector is interesting because the Brexit overhang means that some stocks in the index will be hugely out of favour and others will look like great value because they are Brexit ‘independent’. It would I suppose be a challenge to create a reliable ‘Brexit beneficiaries’ benchmark (although it may have been done – I have not checked), so well run managed funds have an advantage.

Interestingly, the UK mid cap sector is one where managers have done very well relative to the average passive fund over all period up to 10 years, so this is not just a Brexit related result. Having favoured the Standard Life (now ASI) UK Smaller Companies fund on and off over that period, I am not surprised.

So which to buy – active or passive?

I hope it will be obvious from my comments above and the more detailed articles on this site that I am open minded about these two investment options but would take the view that a passive fund is most likely to serve investors best when it tracks a well known large cap index.

For more focused asset weighting calls, a good manager will probably earn her or his keep.

A final thought is that in investing in funds with mainstream benchmarks, one is in effect taking a decision to go along with the crowd. That is fine and a way of playing the momentum factor, but recent experience suggests that benchmark independent fund managers like Terry Smith at FundSmith and Stephen Yiu at Blue Whale make the most money for their investors.

To balance that, one cannot forget one Mr Neil Woodford’s wandering away from his supposed benchmark and the consequences of that streak of independence!