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Active v passive debate not helped by flawed research

I was interested to read the articles which claimed, based on research by Hargreaves Lansdown, that actively managed funds beat passively managed ones. This was apparently based on measuring compounded returns over several cumulative periods of years ending at the present.

The problem with this approach seems obvious but perhaps it will bear illustrating by a simple example. Fund A has returns of 0.5 per cent every single month for five years, after which it will have returned just under 35 per cent. Fund B has returns of zero in 59 consecutive months but in the 60th month it rises by 100 per cent. Fund B will therefore be ahead of Fund A over one, two, three, four and five years even though it actually only outperformed Fund A in one month out of 60.

The article makes the rather dubious claim that this constitutes consistency. I suggest that it constitutes nothing of the sort, as the same (recent) periods are clearly counted in all the longer-term cumulative figures.

Having applied a shaky methodology, it is perhaps unsurprising that the conclusion that “true active management is worth paying for” is going to be slightly shaky, too. Just because some actively-managed funds outperformed passives over a period, how does that help us when deciding which, if any, will do so in the next period? Surely the conclusion is not that all active funds outperformed passives?

The problem is that, even to the extent that there are market inefficiencies that can be exploited by active managers, it is impossible to do so consistently (as in period after period) and the costs of it all wipe out the outperformance, anyway.

Such was the conclusion of an article in the Journal of Portfolio Management in 2000 and several others before and since.

It should be evident that the costs referred to are those of the funds themselves and so do not take account of whatever costs the person recommending the fund to the investor is incurring (and presumably passing on) in their efforts to pick the winners and avoid the losers. If an adviser makes a point of claiming to be able to pick winners consistently, there is something of a vested interest in being able to prove that there is value added by the approach.

Unfortunately, there is much evidence to suggest that the extent to which such winners can be picked consistently is largely explicable by random chance and not skill.

There is, however, far more value to be added by applying the principles of financial planning, whereby the portfolio&#39s asset class exposure is linked to the investor&#39s goals. Perhaps this is where advisers should be focusing more of their attention, particularly in an environment of probable lower future returns.

If the market returns 6 per cent a year, is it better to pay 0.4 per cent to capture the market return or 1.5 per cent in the unproven hope of capturing more?

There is a further problem with using this sort of raw data – the only funds which have a performance record today are those which have survived. A number of funds which real investors purchased in the last 10 years have simply disappeared. Since managers generally tend to keep their better performers and close or merge the others rather than vice versa, this introduces a further confusion into the data and has the effect of overstating the performance of those funds which do survive.

Perhaps this issue was dealt with in the study but there was no mention of it in the article so it is perhaps reasonable to assume that it was not. If the data is skewed, we should not be surprised if the results are skewed also and this once again will tend to make active funds appear in a more favourable light than they deserve on an objective basis.

I am all in favour of debate on the active/passive issue and I do have a high regard for some of the staff at Hargreaves Lansdown. However, this sort of woolly thinking does not contribute much to the debate and might lead more people to conclude that perhaps Ron Sandler might have a point about the inadequate investment skills of IFAs.

Robert Lockie

Certified financial planner,

Bloomsbury Financial Planning, London EC2

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