A client recently asked me how much of his discretionary portfolio would be managed by active funds versus passive funds.

Now this does seem to be a never-ending question, so I thought it might be worth me trying to actually answer it.

However, to answer it properly, I think I’ll need to do it in two blogs, one for active management and one for passive management and then I’ll wrap it up with a summary.

So, let’s begin with a question:

‘Do actively managed funds offer better performance and value–for–money for clients than their counterparts?’

The Case for Active Management

There’s been an awful lot written about active vs passive management. It certainly isn’t a new debate – actually it started back in the 1970’s.

However, you’d had to have lived in a cave for the last few years not to have noticed the growing popularity of passives, especially in the post retail distribution review world (which resulted in improved clarity for fund prices).

But as far as the question of better performance and value–for–money, what is certainly undisputed is that actively managed funds have consistently beaten their indexed counterparts in inefficient markets.

On the other hand, in developed markets this is far less apparent.

There is an old adage that only a third of active managers actually beat the market, but this is a slightly distorted viewpoint because inevitably, when there are winners in active management there has to be losers.

The total value of a market is the sum of the values of the individual portfolios of investors in it i.e. the aggregate of the winners vs the losers.

This leads to active managers often being accused of capitalising on the underperformance of their fellow managers.

Also, comparing performance figures for actives vs passives actually depends on the specific period of time you consider. Certainly, if you take them over a 40 year period then it’s unlikely that the majority of managers could constantly outperform the aggregate for those 40 years. But rarely is a single investment focused for that length of time without changing.

It is worth noting that such studies often do not typically measure performance results on a risk-adjusted basis.

In a perfect world, investors would consider differences among securities with regard to size, quality, liquidity and volatility when comparing active and passive strategies.

It is also quite likely that they would weigh the impact of cash in actively managed portfolios. One could argue that this liquid component lowers risk, but it also has a negative impact on performance during rising markets. This has surely contributed to some of the underperformance by active managers over the long term.

With regard to better value–for–money, well, almost all of the world’s major indices are weighted by market capitalisation. That means passive investors are effectively buying companies whose market values have already risen the most – the very opposite of “buy low, sell high”.

Further, from a value–for–money perspective, many investors may resist investing in a portfolio that includes low-quality companies, i.e. those losing money or are in bankruptcy, those in businesses that offend them, are in overly-competitive industries/markets, are poorly managed, do not pay dividends, etc., as may be the case with an Index but is not characteristic of an actively managed fund.

In the midst of all this, there is no doubt that more research is needed when it comes to choosing the right manager – but then that has always been the case with active management. Ideally, you have the best professionals helping to make decisions.

As an acid test, I printed off a list of funds available on the Old Mutual platform (although I could have used any one of several) and programmed in the funds that have outperformed their benchmarks by at least 10% every year for the last 5 years.

I got a surprise.

OK, I might be teaching you to suck eggs here, but bear with me.

To make a profit, you have to execute both of these decisions correctly.

It’s the Purchase Price

Actually the return on any investment comes down to the purchase price.

In fact, if you’re being really philosophical (and taking a page out of Schrödinger’s cat), you could argue that a profit or loss is actually made at the moment it’s purchased – the buyer just doesn’t know which, until it’s sold.

While buying at the right price may ultimately determine the profit gained, selling at the right price guarantees the profit (if any), in other words if you don’t sell at the right time, the benefits of buying at the right time disappear.

Decisions, Decisions

Many investors have trouble deciding to sell an investment, and sometimes the reason is simple: the innate human tendency toward greed (Gordon Gekko was right).

However, there are several strategies you can use to identify when it is (and when it isn’t) a good time to sell.

The most important thing about these strategies is that they attempt to take some of the human emotions out of the decision-making process and lean heavily on trying to avoid something we call “human behaviour bias”.

Interestingly, the first passive fund didn’t appear on the list until number 21 with the next four or five being well down in the 30’s and 40’s. This surprised me because I would have assumed that there would have been one in at least the top 10 performing funds – but there wasn’t.

• Some more significant benefits of active management are:
• More diverse strategy available (target date returns, for example);
• Better diversification of asset classes (spread of risk);
• Top performing funds outperformed market indices in last 5 years*;
• Costs have fallen in last 3 years due to Retain Distribution Review
• When market momentum ends, active funds come into their own;
• ETF’s must assume that market is constantly growing;
• Single price as opposed to bid/offer which can be large on ETF’s;
• Informed investment decisions based on experience, judgement and analysis of market trends and prospects;
• The ability to take defensive measures should managers expect the market to take a downturn by moving into defensive sectors or hedging the portfolio;
• Index fund managers are not able to move out of sectors or stocks that may be about to decline or use hedging;
• Mispriced stocks can be exploited;
• ETF’s in some countries cannot exploit large caps due to narrow gap of stock in the index;
• Leverage ETF which are double or triple leveraged could lose that in the track index; and
• Trading costs/commission are not always suitable for small regular investment amounts.

Finally, there is an interesting train of thought within some financial circles. It is interesting because it believes that active management is superior by default because passive management is only theoretically possible.

A CFA study of various portfolios over 18 years did not come across a single investor who put all of their cash into a broad market index, ad infinitum. 

Instead, investors either combine them with bond indices or funds, or peel back on the large-caps and add a concentration of small or mid-cap focused investments. 

And when they do that, they become – de facto – active managers.