The active versus passive fund debate evokes considerable passion among investors and analysts alike. If you research the topic you can find yourself surfing for many hours garnering interesting views and opinions on the subject, ranging from serious and controlled academic studies to more anecdotal takes. Perhaps somewhat surprisingly, the subject also gets a lot of coverage in social media, with performance data and news items often commented on and redistributed with as much gusto as any celebrity intrigue.
What strikes me in the publicly available commentary is that the proponents of passive management are considerably more vociferous in their views and more critical in their tone than the advocates of active management.
There is a proselytising fervour within the passive camp that constantly cites the number of active funds that don’t beat their index, charge exorbitant fees, are closet trackers or are generally out to fleece the unwary investing public. The active camp seems to be beholden to a quiet and perhaps uncomfortable diplomacy: there is room for both active and passive, investing is a broad church, and other similarly vague platitudes.
As an ardent proponent of active fund management, I’ve often wondered why its voice is so restrained. I understand that some fund houses, such as BlackRock, have a considerable exposure to both camps and can’t be seen to be undiplomatic. Many active fund groups perhaps feel constrained by modesty when they have a star fund, knowing there is always a risk its style could fall out of favour. The regular lists that name and shame underperforming funds often generate more headlines than a comparable announcement of winners at a fund awards ceremony.
The publication by S&P Dow Jones Indices of the SPIVA Europe scorecard in March 2016 is the most recent study igniting another round of active-bashing. According to S&P, “the majority of euro-denominated active funds” invested in European equities underperformed their benchmarks over the three, five and 10-year periods to December 2015.
Furthermore, these results came in what S&P describes as “ideal conditions in which active managers might be expected to outperform”. The S&P analysis reveals that for the US market 99 per cent of European managers failed to beat their benchmarks over 10 years, while for the typically assumed inefficient emerging markets, 97 per cent of European managers failed to beat their stated benchmark over the same period.
Such statistics are certainly provocative, but they are not necessarily damning for all, and they certainly shouldn’t be justification for an investor to ignore active management. Anybody who believes in active management should be aware that funds can underperform a benchmark; styles fall out of favour, fund managers make the wrong decisions, markets are unpredictable. Investing in active funds requires considerably more background research and ongoing due diligence by an investor, and yes, it’s more expensive.
However, by undertaking research into prospective funds, investors can eliminate the perennial underperformers and considerably increase their chances of picking a winner. The fact is that not all the funds in a study sample have equal interest by investors. Aggregated data don’t reflect the experience of all investors.
It is the attraction of excess returns that drives investors into active funds and the rewards for selecting a good active fund remain substantial. Many studies such as that by S&P compare funds against stated benchmarks. I find it more useful to look at the efficacy of active versus passive fund options by comparing their performance within a classification scheme or peer group.
IA UK All Companies
Looking at the IA UK All Companies sector for the year ended 31 December, the three-year opportunity cost of investing in the best-performing broad-based tracker fund, the Scottish Mutual UK All Share, instead of the best active fund, the Old Mutual Equity fund, was a whopping 64 percentage points.
Over five years to 31 December this opportunity cost was reduced, but the best-performing active fund, Neptune UK Mid Cap, beat the best-performing tracker option, the HSBC FTSE 250 Index, by 56 percentage points. Indeed, in the IA UK All Companies sector to 31 December over three years, 68 per cent of all the active funds beat the highest- ranked broad-based tracker fund, and over five years to the same date 62 per cent of all active funds in that sector beat the highest broad-based tracker fund.
IA Europe ex UK
Looking at the IA Europe ex UK sector for the year ended 31 December 31, the three-year opportunity cost of investing in the best-performing broad-based tracker fund, the Vanguard FTSE Developed Europe ex-UK Equity Index, instead of the best active fund, the Man GLG Continental European Growth fund, was 46 percentage points.
Over five years to 31 December this opportunity cost actually increased, with the best performing active fund (again Man GLG Continental European Growth) beating the best performing tracker option (again the Vanguard FTSE Developed Europe ex-UK Equity Index) by 56 percentage points. Over three years, 64 per cent of all the active funds bat the highest-ranked broad-based tracker fund, and over five years 65 per cent of all active funds beat the highest broad-based tracker fund.
While these numbers do not include exchange-traded funds, which are generally cheaper than tracker funds, they certainly show that for medium-term periods to Decem-ber 2015, active funds more than held their own against tracker options for these sectors. An interesting counterpoint to the findings of the S&P study.
Storm of commentary
Studies such as S&P’s often prompt a storm of commentary and usually bad publicity for active funds, but what is the fund flow reality? Thomson Reuters Lipper’s analysis reveals ETFs and passive funds have rarely had above 10 per cent of the total flows into all European mutual funds in recent years. Reassuring, perhaps, for active fund groups.
However, 2015 was one of the best years for passive investments in Europe, with nearly 40 per cent of fund flows moving into passive options. Although something was revealed in that passive composition: that, looking at the ETF flow component in periods of crises, such as the 2008 financial crisis, the 2011 Europe crisis and the 2015 China wobble, it is probable investors were more concerned about liquidity events than about the active versus passive debate. But, if we see these types of numbers again for 2016 or 2017, some alarm bells should certainly ring for active fund managers.
A single published study is unlikely to exacerbate flows away from active managers towards passive funds, and if it encourages some retail investors to ask questions of their financial advisers and fund groups, that’s a good thing. However, there should be more concern about the cumulative effects of these news flows. The passive voice is getting louder. Online “pactivists” (passive-activists) are increasingly less diplomatic and are prepared to use any study or finding against their active colleagues in order to win market share.
There are, of course, vocal supporters of active funds and a number of supportive academic studies. Practitioners such as Chelsea Financial Services and Square Mile back their fund selection credentials with evidence, as do a number of other fund selectors. Orbis Investment Advisory has been prepared to put its head above the parapet with its concise paper Active Management: a Practitioner’s Perspective, and there are a number of multi-managers who illustrate the benefit brought by active funds to their portfolios.
It is, however, the active fund groups themselves that need to become more assertive, either individually or through trade organisations such as the Investment Association. The diplomatic language adopted by active fund houses in the face of an increasingly innovative, dynamic and noisier passive industry harks back to a different time. If, as I believe, active funds are a force for good in the investment industry, they ought to shout this more loudly.