Active v passive: The great debate

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Which is the best investment style? Active or passive? Pathfinder's John Berry crunches the numbers and comes up with some interesting conclusions and observations suggesting picking styles is a little like picking lanes in rush hour traffic on the Auckland Motorway.

Monday, October 7th 2013, 10:00AM 1 Comment

by Pathfinder Asset Management

In financial markets we like important “stuff” to be prefaced with “The Great....”.  First we had The Great Depression (1929) - in more recent years The Great Recession (2008) and The Great Rotation (2013).  One of the most polarising arguments for investors, advisers and product manufacturers is the question of whether returns from active or passive strategies outperform - this should be labelled “The Great Debate”.

What is active?  What is passive?

A passive strategy essentially “buys and holds” the market it invests in.  A passive international equity investment could for example buy all 500 stocks in the S&P500 with the same weightings as the index. A passive domestic equity investor could buy all 50 shares in the NZX50 index.  A true passive investor will continually rebalance holdings as companies and weights in the index change.  The passive investor would also remain 100% invested in these shares whether the market is rising or falling – seeking a portfolio returning exactly the same as the market return (whether good or bad).

An active investor will deviate from passive portfolio holdings.  An active portfolio may look nothing like the index – with fewer and more concentrated exposures. Or it may have some resemblance to the index – changing company weights or including others from the wider universe.  It may buy and sell frequently or just when markets seem to be trending up or down.  It may also use cash holdings and derivatives for protection.  The aim will be to deliver higher returns and/or lower volatility than the market.

Arguments supporting active

The key argument in favour of active investing is that to some degree markets are inefficient.  This means that information may not be freely disseminated to all participants.  Also, investment skills and technology may not be evenly distributed.  Therefore it is possible for an active investor with better access to information, skills or resources to outperform the market.  Warren Buffet is a living example of the success of active investing.

With a rather unscientific glance at return data published by AON there is evidence of manager outperformance by funds available in NZ.  An international bond fund index (Barclays) shows an 8.0% pa return over 5 years.  By contrast the 5 managers in the AON survey achieved a comparatively stunning average of 9.7% pa.  For New Zealand bonds the index returned 7.1% pa over 5 years while the average of 6 managers surveyed was 8.1% pa.  The result is repeated in NZ equities with the NZX50 index returning 8.3% pa over 5 years while the 5 manager average was 9.7% pa.

News that the “average” manager may beat the market is great for active supporters.   However it is hard to draw firm conclusions from the AON data as only a handful of managers are surveyed.  (Note also, critically, the AON survey is pre-fees which clearly has a return impact).

Another survey of NZ managers is provided by Fundsource.  9 out of 10 managers covering Australasian equities have beaten a 50/50 split of the NZX50 and the S&P/ASX200 over 5 years.  A further 10 out of 16 active NZ equity managers have beaten the NZX50 over 5 years.   The return data from AON (to 31 July 2013) and Fundsource (to 31 August 2013) is set out below.  The numbers in red show where an index has outperformed the funds.  The numbers in bold show the percentage of funds that underperform the index:

This does not tell us whether there are active managers who can consistently outperform the market – it just tells us that the average active manager in NZ or Australasian equities may (after fees) be better than the market.   The follow up question is whether it is the same managers that consistently beat the index and the same that consistently underperform.  Are some managers better at consistently generating alpha than others? 

Arguments supporting passive

The “rely on the smart guys like Warren Buffett” thesis does have its limits.  The team at Long Term Capital Management (responsible for the spectacular US$100 billion investment failure in 1998) comprised the brightest from Salomon Brothers and two Nobel prize-winning Harvard economics professors.  Genius alone will not guarantee investment success – believing otherwise is buying into an emotional argument.  Passive investors argue the debate should be based on data (not dreams).  What does the data tell us?

Perhaps the most widely discussed research in this area is the annual Standard & Poors Indices Versus Active Funds Scorecard (SPIVA).   2013 was its 11th year of publication.  This report focuses on US equity and bond funds – covering domestic US, international and emerging markets.  It does not include NZ shares / bonds – so each investor must draw their own conclusions on relevance to the NZ investment environment.  

The S&P review does not favour active over passive.  Across most categories market indexes outperformed US managers over 1, 3 and 5 year horizons.  (Note that S&P also publish a separate SPIVA scorecard for Australian active managers.  It is not cheerful reading - with the exception of small cap equity about 70% of active equity funds in Australia underperformed benchmark over 1, 3 and 5 years).

The table below compares returns from four categories in the US SPIVA report (note this is a small sample – in US equities alone there are 18 categories).  The numbers in red show where an index has outperformed the funds.  The numbers in bold show the percentage of funds that underperform the index:

Of the 12 active vs index matches above, the index won 11 times.  Over the last 5 years the 4 indexes in the table typically beat active funds 80%-95% of the time.    Not a great advertisement for active.

These results are driving the increasing use of passive in Europe and the US. According to Blackrock, since the onset of the GFC (2007) total net flows into active equity and bond funds have been virtually zero while flows into passive equity and bond funds total €1.5 trillion.  In Europe the use of passive products has doubled over this period.

Why the answer is not always clear

Despite the strength of feeling on both sides of the debate, there is no right answer.  The active vs passive debate may be more nuanced than just asking if one or the other is better.   There are some real subtleties in the analysis.  Here are a few examples:

1. Is the excess return really true alpha?  Is the bond fund outperforming the benchmark because 20% of the fund is invested in dividend shares (i.e. it receives a premium for taking equity risk) or because it is invested in unrated bonds (i.e. it is rewarded for taking credit risk)?  Is the equity fund outperforming the market because it is invested in small cap stocks (reward for taking liquidity risk), because it only has only 10 holdings (concentration risk) or because the fund borrows to invest (leverage risk).  There is nothing wrong with taking these risks – except that any resulting “alpha” needs to be understood as higher return for higher risk.  These factors make sensible comparisons very difficult.

2. Does the active manager use a fair benchmark?  Does the benchmark index have a high weighting to one or two stocks making it easier to “beat” the market whether by skill or chance (i.e. inefficient benchmark)?  Or does the investor compare an international share investment with currency hedging to a benchmark that has no hedging (here the alpha could be currency not equities expertise).

3. Is there data mining going on?  With both the Fundsource and AON surveys mentioned you can pull examples of the average manager outperforming or underperforming the index.  For example in NZ fixed interest and international bonds the average manager in the Fundsource survey failed to beat the index over 5 years – the opposite result of the AON manager survey.  Both the AON and Fundsource surveys will be missing funds that if added could change the result again…. You can find whatever result you are looking for (as Nobel winning economist Ronald Coase noted - if you torture the data for long enough it will confess to anything!).   

4. The S&P SPIVA report identifies several more issues to watch.  S&P adjust for “survivorship bias” - many poorly performing funds are liquidated or merged which affects the data (27% of US equity funds have in the last 5 years been merged or liquidated).  S&P also track “style consistency” where funds can diverge over time from their original investment style (only 47% of US equity funds have maintained a consistent style over 5 years).

The key is that investors need to understand the risks they are taking and how these deviate from the appropriate market risk.  Investors also need to understand how the market return is measured - is the index choice appropriate (for example returns from the NZX50 index and NZX50 portfolio index are different – advisers should be aware of the differences). 

What about “blending”?

Blackrock (owner of iShares) produced a report on the use of active strategies in a portfolio alongside index products (called “blending”).  Using  active or passive is not a binary choice – they can be blended to complement each other.  Blackrock interviewed 35 institutions across 8 countries managing a total of €2.4 trillion.  A few key points from the study:

1. Close to half the respondents describe themselves as agnostic to whether they use active or passive funds – it is just a question of how you get the best exposure. This requires a mix of quantitative analysis and qualitative judgement.
2. Client needs and expectations are an important driver.  Do clients focus on low cost product (particularly in a lower return world?). Do they expect stock selection as part of the adviser’s value proposition?  How important is transparency for clients (and does transparency build trust for advisers)?  Do clients want to know they have access to all available types of product – and does finding a “suitable” product require you to consider all options?  Does the investing time horizon have an impact?  In short – don’t disregard your clients when thinking about the active vs passive debate.
3. Finally Blackrock report there is a “high level of consensus” that there will be a shift away from “active managers centred on close-to-benchmark portfolios” being replaced by indexing combined with “higher active alpha” managers.  This implies a shift to “blending” active and passive strategies.

A sensible active / passive analogy?

Often the best way to think about an issue is by analogy.  The best we can come up with is that investment style is like driving down the motorway in rush hour.  Imagine three lanes of a motorway heading into the city at 8:00 am packed with slow moving cars.  At times some lanes move at different speeds  - and sometimes a lane stops completely.  One (passive) strategy is to sit in the inside (fast) lane and just assume that most of the time you’ll do ok.  Another (active) strategy is to jump from lane to lane trying to pick the fastest moving. What strategy gets you to work fastest? 

May be its not a great (or very scientific) analogy for investing, but it makes the point.  On some days or on some parts of the motorway active is better.  But you won’t outperform the fast lane - unless you are very skilled (can shamelessly squeeze into small gaps), have better information (traffic news updates on the radio!) or the “market” is inefficient (there are not many cars on the road).  Often the lane hopping ends in frustration – and a passive strategy works best – it certainly has a lower risk of accident!

Concluding thoughts

In this commentary we haven’t touched on some very “real world” issues such as the effects of different fee structures.  There aren’t enough hours in the day to look at every aspect of the active / passive debate!   Here are some thoughts on whether to favour active or passive or some mix of the two:

Look at the data:  in deep liquid markets offshore the academic research is quite heavily in favour of alpha generation being difficult to achieve and repeat over sustained periods.  Not impossible, but difficult to replicate year after year (one year’s outperformance could be luck, 5 years of consecutive outperformance is skill – but it can be hard for investors to identify and then access).

But the debate is not simply data:  Look at the active vs passive debate from all angles.  Is the index used appropriate or sub-optimal?  Is the alpha just a result of taking more risk than the index?  Is it possible that selective data has been used to prove a point?   Has a manager changed its style?  It is not just a matter of looking at some return numbers and drawing an instant conclusion.

Is the NZ market different?  Some markets or asset classes may be different to others.  In New Zealand we have a less liquid market with an index over-represented by utility companies and high weightings to Fletcher Building (12.4%) and Telecom (8.1%) – in fact more than 40% of our market is in only 6 stocks.  Alpha generation may be easier given these constraints – this is different to highly liquid and well diversified US, European or Asian markets.

Think about “blending”:  Blending is the use of both active and index funds to complement each other in a portfolio.  Remain open minded about whether an active or passive solution (or a blended combination of the two) is appropriate – the objective is to find the best solution for clients.

The answer may be elusive:   Active vs passive discussions can be animated – there are strong believers on both sides with a wide range of views backed by endless academic studies.  The debate has continued for decades and has not yet been settled – there can be inconsistencies across asset classes, time periods, market conditions and geographies.  Perhaps we have to accept that for The Great Debate there is no single right answer…..

Pathfinder is an independent boutique fund manager based in Auckland. We value transparency, social responsibility and aligning interests with our investors. We are also advocates of reducing the complexity of investment products for NZ investors. www.pfam.co.nz

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