PWL Capital November 27, 2017 Advanced Investing Active versus Passive: Beyond Tribalism When it comes to your money, facts matter. It is prudent to look beyond labels and identify what controllable factors help or hinder investment performance. The investment world often appears to be occupied by two tribes: active investors and passive (index) investors. Active investors are characterised as trying to beat the market by claiming to know something about the future either in terms of the direction of the market (market timing ) or identifying individual securities as under or overvalued (e.g. stock picking). Conversely, passive investors prefer a rules based approach that follows a market as closely as possible and, by keeping costs low, captures the bulk of market returns. It is entertaining (sometimes literally as in the movies Wall Street and The Wolf of Wall Street) to characterise active investors as suckers for unpleasant Wall Street types whose only purpose is to transfer money from the investor’s pockets to their own. Conversely passive investing has been called un-American1 (but not, as far as we know, un-Canadian), worse for society than Marxism2 and responsible for the high cost of air travel3. In a recent report, Vanguard, a supplier of active and passive investment funds, sidestepped the mudslinging. Specifically, Vanguard looked at both active and passive funds and identified key properties of both that acted as a drag on performance. The next three paragraphs explains the Vanguard analysis in more detail and can be easily skipped if you just want to get to the conclusions. Vanguard assesses the performance of US funds against a factor model. A simple way of benchmarking performance of a U.S. fund is to compare it with an index of all U.S. stocks weighted according to their market value. If the fund was invested in 60% US stocks and 40% US bonds we would say that it had 60% exposure to the market factor. The past few decades of research have revealed other factors that, over time, contribute to investor returns: company size, value, and momentum. The important point about factors is that they can be exploited by a rules based investment strategy, without the need for active managers. The starting point for the Vanguard study was to ask if fund managers are able generate “alpha”, where positive alpha is characterised as performance above what would be expected from a rules based, factor analysis. Consistent with other research, Vanguard concluded that before fees the average alpha generated by the funds studied was indistinguishable from zero, and was negative after fees by roughly the amount suggested by the fees. Not unexpectedly the variation of active fund’s performance was much higher than passive funds. The authors give the example of 2008 when active mangers varied from the average market performance (which was a decline of -37%) by +10% to -20%. This undermines the claim that active managers can protect against down markets. In addition to high fees, high portfolio turnover, was also negatively associated with fund performance. Turnover represents the percentage of portfolio holdings that have changed over the year: a low turnover (20-30%) is considered close to a buy and hold strategy but a turnover of more than 100% would be considered a high turnover4. The message from the Vanguard study is simple: avoid investment strategies (passive or active) that have high fees and/or high portfolio turnover. The detrimental impact of high fees is well known and easy to understand; fees are deducted directly from fund returns, and the investor gets the difference. High portfolio turnover also acts as a drag on returns because of higher trade costs. The claim from active managers that high turnover increases alpha by selling stocks that will underperform and buying stocks that will outperform, is not supported by this study. Under new disclosure requirements fund companies disclose management fees (MERs) in an accessible Fund Facts document. High portfolio turnover is not so easily accessible, but is available from research companies such as Morningstar. Fund Facts report a trading expense ratio (TER) which can serve as a rough proxy for portfolio turnover. Only a few years ago life was rather simpler with active funds tending to be higher turnover and higher cost compared with passive ETFs and index funds that tracked broad market indices. Now we have a cornucopia of investments that blur these boundaries: funds that pursue a low cost index strategy, ETFs that are actively managed and a middle ground occupied by a range of strategies that blend passive and active characteristics: smart beta, factor investing, low volatility models, to name a few. As the Vanguard report reminds us, “fund characteristics are more important than the active and index labels”. 1 https://www.vanguard.com/bogle_site/sp20040413.html 2 https://www.bloomberg.com/news/articles/2017-10-17/sanford-c-bernstein-compared-passive-to-marxism-now-has-2-etfs 3 https://www.economist.com/news/business-and-finance/21731333-criticism-index-tracking-funds-ill-directed 4 Security lending can be a source of revenue for fund companies that can reduce total trading costs, even when portfolio turnover is high. Share: Facebook Twitter LinkedIn Email