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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

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Comments

There are 3 comments at the moment, we would love to hear your opinion too.

  1. Good for you Chris. Another interesting slant on the topic and many salient points. I have written and researched on this subject for many years. I haven’t been tasked to submit a detailed polemic, but would just add a few more arrows to the quiver:

    1. If we all became Pacifists (By following their convictions) then who would be left to actually invest? Logically therefore the pacifist treat the activists as the mugs to create the market into which they invest.
    2. As Chris has inferred it is invariably the Investment Trusts that actually do outperform the markets over time. I have long suspected that acolytes of passivism are so because at root they don’t really understand nor have the skill sets to undertake active investment.
    3. Passivism has no discretion and therefore the management of companies are mostly left alone. They could have the worst corporate governance, but If they are in the index they attract investment.
    4. Many who are keen on passive point to their seemingly lower charging. This is used often to offset their own exorbitant charges, so at to make the total cost of ownership look less frightening.
    5. It must also be recognised that investing is not only about how much you can make when markets are doing well, but how little you can lose when they are doing badly – and this is where passives fail spectacularly. Diving off the top board without trunks. Active management can (and should) be at least some defence in falling markets.

  2. Paul Lewis tweeted an article yesterday saying…. “the battle is over. Active Lost” quoting an FT adviser article picking up 1 year under performance by UK active funds. A similar line was raised by Investment Week.

    I’ve challenged much of the content in the articles but no response which is frustrating. Make sweeping comments, refer to an article and move on!

    One comment in the article was “data from S&P found that all active emerging market equity funds had failed to beat their benchmark over 10 years”. A quick bit of basic (FE) research showed me that Stewart GEM Leaders delivered 219% vs the benchmark MSCI EM of 105%.

    Given no-one will explain the source of this ‘statistic’ – I can only assume that it is seemingly wrong given that the first fund I looked at doubled returns of its benchmark net of charges. The second fund (Aberdeen EM) also comfortably outperformed. Given the silence, I didn’t go any further with other funds.

    Turning to 2016, Paul Lewis also made the throwaway line “… but no doubt many advisers will gamble clients’ money again”. Now, I suspect that given the reversal of the BoE Interest rate strategy, the Brexit vote and US election, many UK active managers were somewhat defensive and therefore (IMO) the gains made Qs 3 and 4 were initially the significant fall in Sterling (benefiting UK companies trading overseas and UK investors investing overseas) and subsequent gains on the FTSE100 as a result of overseas profits being boosted by Sterling. We then had a rally following the US election with the FTSE 100 hitting all time highs (ignoring dividends).

    However, the reverse could have happened – and therefore something out of the control of individuals benefited those of us exposed to equity – for me the gamble was that it was ‘chance’ that these outcomes happened to pay off – had the reverse been true, perhaps 90% of actives would have outperformed (no doubt triggering headlines … “Active has won”.

    Active managers were perhaps hedging currency / market risk and therefore whilst over a short term horizon active managers disappointed, I’d suspect the risk many were running was lower.

    Active vs. passive needs to have a level headed consideration – but it seems that those who are most adamant and vociferous that it’s a non debate are always on the passive side of the debate. As an IFA, we look at the whole argument and as a result hold passive and active BUT time and again I look for a passive solution in certain areas and return to active funds.

    With regard to Harry’s point above, my views would echo point 4 of his as it appears that there is a mutual exclusivity between higher advice fees and active management and that there seems to be a trend to charge more for advice and offset that by selecting passive funds. If there is indeed a correlation, there shouldn’t be!

    One is for a planning/advice service, on is to pay for investments. The underlying investment strategy should not reflect the cost / nature of advice – after all, ask a client do they want cheap funds or funds that offer good value, I suspect a majority would prefer the latter.

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