Passives giant Vanguard on whether now is the time to go active

With Brexit negotiations appearing increasingly fractious, and concerns about North Korea growing, many investors might wonder if the time is right for active outperformance. Are the Bank of England’s recent rate rise and widening spreads in the bond markets signals of a changing investment environment?

It’s true that price dispersion at the security, sector or market level gives active managers the opportunity to outperform. The current argument is that Brexit negotiations, and other global events, are likely to produce a period of heightened volatility and price dispersion, creating a fertile ground for active managers. That argument might seem logical, but in practice markets are very hard to predict. While it seems likely market volatility will rise, we can’t state confidently the path the market will take, as the Brexit vote and US election remind us.

Additionally, investors must be comfortable taking on the risk that active investing, as a deviation from the benchmark, generates. And while the opportunity for alpha might exist, managers still need to have the talent to turn that opportunity into outperformance. All price dispersion of securities does is it increases the magnitude of the outcome. It doesn’t necessarily make it easier for fund managers to identify the winning and losing securities.

At Vanguard, we have been in the business of offering active funds to investors for over 40 years. We believe investors first need to be able to identify who these talented active managers are. Our own process when identifying active managers to work with focuses on the stability of the firm, the fund management team, the philosophy of the managers and the clarity of the investment process.

Finding talent isn’t enough, investors must obtain access to this talent at low cost. Our years of research find low cost plays a crucial role in long-term outperformance.

Finally, investors should practise patience. Even the best active managers are likely to suffer periods of underperformance. Consider this: with hindsight bias, if a UK investor picked a successful active equity fund at the start of 2002, they would have had to stomach two thirds of those funds underperforming for at least three consecutive years at some point over the last 15 years.

So, is now the time to go active? History shows us that active outperformance comes and goes and past performance is certainly no guide to the future. As such, it would be unwise to try to time entry and exit points for active management. Instead, when making the active/passive choice, investors should think about their long-term goals and attitude to risk. If they wish to allocate some of their portfolio to active funds, they should consider the three ingredients of talent, cost and patience that we believe provide the best chances of long-term success.

Ankul Daga is a senior investment strategist at Vanguard Europe