The active/passive debate surfaces - again
A recent Government-commissioned report in the UK, along with falling markets has ignited the active/passive debate again.
Tuesday, September 3rd 2002, 8:59PM
In the business of managing other people's money, one of the longest-running debates has been over the best way to buy shares.
Do you use an "active" fund, for which managers try to pick the most profitable shares, or do you put your money into a "passive" fund and accept whatever the market gives you?
The basic arguments are simple. Passive managers say active fund managers can't consistently beat the market over the long term, and can trot out plenty of studies to back that contention.
Those in the passive camp also argue that the tax benefits enjoyed by New Zealand passive funds - they don't pay tax on capital gains, while active funds must surrender 33 per cent of their gains - make the hurdle even higher for active managers.
Recently, the passive managers gained some major support from a Government-commissioned report in Britain.
Commissioned by the Treasury and written by the former head of Lloyds, Ron Sandler, the report says investors pay a lot for active management but aren't rewarded with increased returns.
It also casts doubts on how "active" some funds are. The report says active funds have become more like passive funds.
"Interview evidence suggests that tracking errors [the difference between a fund's performance and the overall market] for actively managed retail funds have typically shrunk considerably over the last 10 years, from perhaps 3 to 4 per cent for an average risk or "balanced" fund to as little as 1 per cent.
"The result is likely to be that undiscerning retail investors will pay charges appropriate for active management in return for management which is quasi-passive."
It also points to a difference in the way individual investors go about choosing managers, as compared with wholesale or institutional investors.
"One would expect to find that institutional investors as a group made somewhat greater use of active management than retail consumers, since they are typically better equipped to identify outperforming fund managers.
"The reverse is the case. Retail investors are incurring the additional costs of active management when there is little chance of them achieving higher returns to compensate for this."
The case for passive funds has some high-powered support in New Zealand. For example, Craig Ansley, who heads consulting firm Frank Russell, is a firm believer in the passive approach.
To him, one of the big benefits is the tax advantage. He can't understand why any investor or adviser would use a structure which pays tax when they don't have to.
Investors who use funds which don't pay capital gains tax "are miles better off" than those who put their money into funds which are taxed, he says.
But while the argument for using passive funds might stack up if you are investing in international shares, the case is much less compelling when it comes to investing in New Zealand.
Figures from managed fund research house FundSource show that the majority of actively managed funds in New Zealand have significantly outperformed the index funds - bar one.
The exception is the MidNZ fund, a passive fund which invests in mid-sized companies and whose performance has come in around the middle of the pack.
Some of the reasons for this are that it owns a broadly diversified range of companies and has good exposure to "defensive" type shares, including property and infrastructure.
Lately its performance has been boosted by the rise in Air New Zealand's share price.
This has been positive, but the danger is that the company now makes up 15 per cent of the midcap index. Should Air New Zealand's share price collapse, as some predict, the MidNZ fund will suffer.
Air New Zealand's influence in the MidNZ fund helps explains why passive funds in New Zealand find it so hard to beat the active managers.
The market is heavily weighted towards the big companies. The top 10 companies account for 57 per cent of the entire market's value. The largest stock, Telecom, makes up 21 per cent of the market.
These large companies have generally performed poorly over recent years, dragging down returns from passive funds.
Former Guardian Trust equities manager Ian Arkle says active New Zealand managers have been able to consistently beat the market by buying companies that aren't among the market's big names.
Many of these companies are not well-researched, making it possible for managers to find undiscovered gems.
The FundSource figures also show that managers who are less constrained - those who invest without keeping an eye on a particular index - are the ones who have performed the best. Since 1999, Fisher Funds has had the best performance among New Zealand funds, producing an after tax return of 12.5 per cent a year.
The next best performers also don't follow an index. But they differ because their mandates allow them to invest a portion of their money into companies which are listed on the Australian Stock Exchange.
These funds are JB Were's Trans Tasman Equity trust and AXA's Select Australasian equity trust.
Cameron Watson, research manager at ABN AMRO Craigs, says another reason index funds don't do as well in New Zealand as they do overseas is to do with the composition of returns.
Overseas shares generally deliver most of their returns in the form of rising share prices, producing capital gains for investors.
But unlike most other markets, the local sharemarket delivers a large proportion of its returns as dividends. All funds - passive or active - pay tax on dividends, so the passive funds' ability to avoid tax on capital gains is less of an advantage here.
Some sharebrokers, such as First New Zealand Securities and JB Were, offer a middle path between passive and active funds.
These are "discretionary portfolios". Essentially the brokers put together a portfolio of stocks based on their research. The investor follows the broker's recommendations, but buys and holds the shares directly, rather than through a manager.
This essentially gives them a tax-effective fund, because individual investors generally don't pay tax on capital gains.
While the case for passive international shares stacks up, they don't look particularly stunning right now. The graph of any of these funds resembles the slopes of Mt Everest - heading downhill.
The current environment also exposes one of the weaknesses of the tax argument - tax advantages are no advantage when share prices are falling.
On the way down, index funds don't get to build up tax losses which they can use to offset future gains, so their losses are essentially amplified.
Active funds now look quite attractive, as most of the tax to pay on past gains has worked through the system and they are now accumulating tax credits.
When markets do start climbing, they will be able to use these losses to bolster returns to investors.
What tends to be happening now is that people who use active and passive funds in their international share investments are switching the weightings around.
Gareth Morgan, of Gareth Morgan Investments, says that a few years ago, passive funds made up the bulk of his overseas share holdings. Now the ratio has been swapped and index funds are around 20 per cent of the allocation.
The reasoning is that because the markets are having some trouble, and there are issues of corporate fraud and failures, an investor is better to take a "stock picking" approach, rather than buying the whole market, which is what you do when you invest in a passive fund.
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