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The Case for Passive Investment Management

The Case for Passive Investment Management

Last time I spoke about the case for ‘active investment management’ and all its merits.

Now I’m going to make the case for ‘passive investment management’ – let’s start with a statement:

Tracker funds and ETF’s are the future and are superior to their counterparts

Active management at best is a zero-sum game and at worst a negative sum game.

What do I mean by that?

Basically, I mean that even before we have hired a manager, the likelihood of our outperforming the market by investing in an actively managed product is almost always much less than 50%.

All portfolio returns that beat the market are offset by other portfolios with lower returns … because the market is the sum of its parts.

This is because, in real terms, the market is the sum of the investors in it and therefore growth in that market is the aggregate of the winners and the losers. Most of active management then is simply the redistribution of existing wealth between customers, whether individual or institutional.

By investing passively, the investor gains exposure to broadly diversified lists of stocks or bonds that target specific investment styles in the most tax-efficient manner. The performance advantages of this over long periods of time are in no small part the result of low fees and expenses as well as limited portfolio turnover that mitigates trading costs and taxes. The passive investor also has the luxury of avoiding the challenges and costs associated with selecting successful active managers.

As we’ve discussed previously, the impact of charges on an investment return can have a dramatic effect over the course of an investment cycle, so when the average passive fund cost is 0.19%, compared to its active counterpart at 0.80%, that’s a very big difference.

However, you’d pay that if the performance was better, right?

Well, a few years ago two very eminent financial analysts, Richard Ferri (CFA) and Alex Benke (CFP), conducted an in-depth study of the exact performance in the US between active and passives. Their resulting document was simply entitled the ‘White Paper’ – and it made compelling reading (well, at least for investment geeks like me).

In it they showed a number of investment scenarios they had created –  each scenario began with a pre-selected index fund portfolio that was available to all investors. This portfolio was then compared to 5,000 simulated trials of all active fund portfolios that were also available to all investors. A time period of the previous 15 years was chosen to analyse the data because this included a full investment cycle, not to mention a large crash (2008).

They found that the passive index fund portfolio outperformed the randomly selected actively managed fund portfolios 82.9% of the time during this 15-year period. There were 4,144 underperforming actively managed portfolios and 856 outperforming portfolios.

The average annual performance shortfall of the losing portfolios was -1.25% annually and the average outperforming portfolios beat the index fund portfolio by 0.52% annually. So, on average, where the active fund beat the passive, it wasn’t by as much as when the passive beat the active.

The graph below shows how, when increased over time, the passive funds winning percentage increases according to the survey:

passive-investmentchart.png

More worrying though was the number of active funds that had actually folded each year.

Research by Vanguard found that 46% of active (mutual) funds available in January 1997 were no longer in existence by December 2011. The study also noted that these funds tended to have poor performance over an 18-month period prior to closing or merging. These funds could not be included in the survey.  Why? Because they didn’t exist, so the results were not as harsh on actives as they could (and should) have been due to being skewed.

Some other worthwhile observations for the case of passives:

  • More tax efficient because CGT is paid on sale
  • Lower overall expenses (TER’s average at 0.19%)
  • Market, sector and stock analysis is not required, therefore the decision to produce the right selection is not necessary so it will always perform with the index
  • Few active managers manage to beat their benchmarks consistently
  • Many ‘active funds’ are nothing more than closet passives
  • Range of ETF strategies available (commodities, energy, precious metals, property etc)
  • ‘Actively’ managed ETF’s are now available
  • Can be bought at variable trade price throughout – managed fund price at end of day.
  • ETF dividends are re-invested immediately, unlike managed funds which might have a delay
  • ETF’s often trade near their NAV (arbitrage will bring it back in line)
  • Survivorship – often actives are reliant on specific individuals for management, when they move the fund

Next time, I’ll round up my thoughts and reveal my preference in the great active vs passive debate.

 

money max

Disclaimer: This blog is an expression of the individual author’s views on topical issues and does not necessarily reflect the views of the publisher. It is not intended to be comprehensive or the provision of investment advice. No liability is accepted for the opinions it contains, or for any errors or omissions. In all cases, you should seek professional advice specific to your circumstances. Published by © Moore Dixon Isle of Man, an independent member firm of Moore Global. Moore Global is regarded as one of the world’s leading accounting and consulting networks with 547 member and correspondent offices in some 113 countries. Moore Dixon Financial Services Limited is a company incorporated in the Isle of Man No. 111421C. Licensed by the Isle of Man Financial Services Authority.