The Active vs Passive Management Debate

by Mark Moir
Active vs Passive Fund Management

The Active Argument

Karl Leinberger from Coronation's Active Managers, recently explained his views on the differences: "Over the last few years passive funds have significantly increased their share of global assets under management. I have tried to stay out of the active versus passive debate, but have had so many questions from clients on this topic of late that the time has come for me to give my 'two cents' and try to debunk a few myths."

The passive sales pitch typically goes as follows:

  1. Markets are efficient
  2. Most active managers underperform the market
  3. The odds of selecting those active managers that will outperform in the future are not good

It is a compelling sales pitch, until one slows it down and unpacks it:

Firstly, the pitch leaves one with the impression that passive funds deliver returns very close to those of the market, when this is often not the case. At the risk of making an obvious point we should note that, while many active managers typically do underperform the market, 100% of passive funds underperform the market – 100% of the time. This is a mathematical certainty. Passive funds endeavour to replicate their benchmarks. After costs, it is their destiny to underperform those benchmarks. The less well-known point is that the performance gap for passive funds is a lot bigger than one would expect. An analysis of the full universe of passive unit trusts that tracked the ALSI and Top 40 benchmarks over the last 10 years shows that the average underperformance of this universe has been a staggering 0.95% per annum, at least twice the number I would have expected. We do not have access to the underlying data, but I think that the bulk of the performance gap has come from passive managers charging active-type fees for a passive service (the average fee charged by passive unit trusts seems to be around 0.57% after VAT).

Secondly, it really should not be a surprise that so many active managers underperform the market after fees. It isn’t a conclusion that deserves much fanfare; if you think about it enough you realise that the debate around the efficiency of markets is a red herring. Alpha is after all a zero sum game, given that the sum of all investors’ returns cannot exceed the total return of the market. This makes it close to a mathematical certainty that the aggregate return of all active managers will not beat the market. Once you add in fees and other costs many active managers end up underperforming.

This takes us to the key point: investors don’t buy the full universe of active managers. I have yet to meet the client that has bought each and every one of the 130-odd general equity unit trusts available today. Most of them, with the support of an independent financial advisor in the retail market, or an asset consultant in the institutional market, will diversify their exposure between three or four active managers. At Coronation, we don’t think that the task of identifying the winning long-term active managers is that daunting. A portfolio of the long-term winning active managers has delivered outsized returns when compared to the market (as well as significantly better risk and volatility metrics). Over long periods of time the numbers have, in fact, been nothing short of retirement changing. Will every one of these active managers outperform in the future? Probably not, but I’d happily bet that a basket of them will comfortably beat the market after all fees and costs.

The Passive Argument

The following is insight courtesy of Jack Bogle: "Don't let the miracle of long-term compounding of returns be overwhelmed by the tyranny of long-term compounding of costs."

Passive investing is argued to be one of the most robust investment strategies based on research that shows most actively managed accounts tend to show lower or the same returns as a passively managed account investing in similar products. The differentiator is the compound benefit of lower management costs over the investment period. A 1% saving on costs, means a 1% higher rate of return. Therefore the aspect that matters is keeping the fees and costs of investing to a minimum.

Passive funds track a certain index, such as gold, bonds or several indices and stay within a predictable rate of return. With a spread of indices being tracked it ensures a diverse portfolio which is more hardy and offers more consistent returns.

Rebalancing is a key element for passive funds as if certain elements outperform or underperform from the designated range then the fund is reconfigured to stay within the desired returns range. This ensures consistency with stable returns.

So How to Choose

Performance is often used by investors when buying funds and by fund managers when selling them. The problem is that performance reflects the past and doesn't accuratly predict the future. You are unlikely to get the same returns in the future simply because markets change. What performance does tell us, is the historical success or failure of a fund which can inform fund selection decision making in both positive and negative ways.

Using different time frames when looking back on performance tells very different stories. To illustrate this, take a look at the tables below:

Passive Fund Returns
Fund 12 months to 18/07/15 12 months to 18 Jan 2016
RMB Cautious Fusion 7.43% 1.17%
SATRIX Low Equity n/a 5.05%
Nedgroup Core Guarded 9.75% 6.35%
Active Fund Returns
Fund 12 months to 18 July 2016 12 months to 18 Jan 2016
Allan Gray Stable 4.64% 14.58%
Coronation Balance Defensive 7.67% 6.83%
Investec Cautious Managed 7.51% 10.17%

Another consideration when reflecting on past performance is a metric known as "Maximum Drawdown". Maximum Drawdown represents the maximum percentage of one's investment that could be lost if a person bought a unit trust at the highest point of the biggest losing period for that fund, and sold it at the lowest value over the same period. Because the passive funds under analysis are very young (less than 2 years) we can only reflect their maximum drawdown performance over the last 12 months.

Active vs Passive Fund Maximum Drawdown
  Fund Maximum Drawdown
Passive Funds RMB Cautious Fusion 7.27%
SATRIX Low Equity 4.49%
Nedgroup Core Guarded 3.68%
Active Funds Allan Gray Stable 2.55%
Coronation Balance Defensive 2.3%
Investec Cautious Managed 2.67%

In Summary

Based on this very small sample of funds and a short investment comparison period, it is clear that a good active manager can be well worth the extra fund management fees -particularly in a volatile market such as the one we currently face. Active managers seem to have a better ability to reduce downside risk than their passive counterparts.

As an independent financial advisory, we still offer our investors the choice of both passive and active funds, and may recommend passive over active in certain scenarios. Contact us if you have any questions in this regard.

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