Chris Gilchrist: Finding fault with the passive evangelists

Why would you buy an index tracker fund? Because very few active fund managers consistently generate higher returns than a representative market index?

That is not – as many passive evangelists think – a slam-dunk proposition. The degree of market efficiency varies from market to market and among sub-sets of stocks within markets over time. Who would want to own a conventional tracker fund in which one stock, with a substantial government stake, accounted for two-fifths of the index? Let’s be clear: tracker funds do not track the market because “it is not a stockmarket; it is a market in stocks”. If you think the index is the market, you have been brainwashed and ought to leave the investment business immediately.

The best way of thinking about any passive fund is that it is a portfolio constructed and adjusted according to a set of rules. There is only a trivial difference between “smart beta” funds and conventional market-cap-weighted index trackers. Note that market-cap weighting is an outcome of Markowicz’s child, portfolio theory, which remains just that: a theory that explains some things about the stockmarket.

The first open-ended equity funds – launched by M&G in the 1930s – were fixed. They held a fixed set of stocks and there were a few substitution rules to deal with takeovers or bankruptcies. The problems of fixed trusts quickly led to giving fund managers discretion. By the 1960s “gunslinger” managers traded like bandits and, ever since then, the average holding period for stocks within open-ended funds has declined in the US and the UK.

The average holding period for pension funds, insurance companies and closed-ended funds has remained much higher than for open-ended funds. Short-term performance pressures cause active open-ended managers to trade more, as is proved by US fund flows showing individual investors chase top-performing funds. This is investment consultant Charlie Ellis’s “loser’s game” (see Ellis’s slim and classic Investment Policy) and, as opposed to playing this game, a tracker fund may seem a good idea.

But plenty of active managers avoid the curse of the loser’s game by not trading. In fact, combine active share (80 per cent plus) and low turnover (under 20 per cent) as selection criteria and you will find most UK actively managed funds with superior long-term performance in your list.

There is an irritating inconsistency in the approach of many passive evangelists. Their choice of passive is based on portfolio theory. That theory also says you cannot time the market: you cannot make consistent returns by buying and selling the market as a whole any more than you can individual stocks. Yet lots of passevangelists use passive funds to implement active – often hyperactive – asset allocation in which they do buy and sell the markets.

Using active asset allocation turns passevangelists into active managers (actipassevangelists? Or shall we just call them contras?). Yet if their choice of passive vehicles is based on academics’ insistence that it requires over 15 years of data for active managers to prove their success is through skill rather than luck, the same logic says most contras will be retiring before they can prove they are any good at their job.

Chris Gilchrist is director of Fiveways Financial Planning