Since I have been around investing, the debate of Active vs. Passive has raged. It has never been conclusively settled, but it is always an excellent argument to be the fly in. The evidence supports the passive argument (as long as you look in the right place). Most data series over time would support the passive argument (if you don’t dig too deep). However, that simple exercise is insufficient; I have yet to find a data set that is not fundamentally flawed. For one, there are many bad active managers out there dragging the averages for active data, and very few studies are made with constrained data sets and small sample sizes of qualifying managers—how you then qualify an active manager for this pool creates another problem!
Survivorship bias also skews the data—the defunct active manager isn’t in the data, right? They’re trying to rally investors to start a new fund under a different name! Simply, only exceptional fund managers will beat the market. With the headwind of cost and efficiency (enough/maybe) against the active manager, the market portfolio is out of the blocks first. So, given the active indices we all use to cut the data – I just don’t buy it.
An index outperforming poorly constructed Benchmarks populated with poor active managers proves nothing to me. But let’s, for the sake of argument, suggest that some of the exceptional active managers can outperform a market portfolio – think investment trusts, a few hedge funds, some long-only equity-only funds – but that you’re probably not able to identify them all of the time.
The question that seems more relevant then, and which we never get asked, is not what will win, active or passive (we get asked that all the time)—more, can investors consistently align with exceptional, consistent, and ultimately market-beating active managers? Is this Holy Grail of retail investing and the consistency of stock selection possible/probable? The answer is simple, improbably possible.
Depth of knowledge, data obstacles, and a lack of deep due diligence (DD is mainly a post-decision justification rather than technical investment work) all present serious, if not fatal, challenges for most small retail financial advice firms. Therefore, passive perhaps seems to triumph as the logical choice if you can’t seek out exceptional managers and hold your place there—possibly returns are thus more probable in passive.
However, outperformance in active is very possible.
Therefore, if the likely outcome of seeking Alpha (through Active) is to fail to find it, then buying Beta (through Passive) is perhaps on balance—the optimal client outcome. What I don’t get, however, is what happened to the smart Beta, the factor tilts, and the screened passive. I’m not talking here about a Hybrid, an active manager using passive to lower cost and take Beta – I want to see an actual passive portfolio but done better.
Think it through: the average multi-index passive portfolio with equity, or near equity, market volatility will most likely be 50% or more in the US and the UK, probably only buying trackers on the S&P 500 in the US, majoring on the FTSE 100 in the UK with perhaps a smattering of mid-caps. Say 600 stocks in total, but under the hood of this, how many of these companies are there just because of the index’s calculation methodology – do they show promise, growth, and potential?
Would they ever make the desk of an active equity manager? Perhaps not. Indeed, some are terrible buys – but we are happy to own them on mass just because we believe in passive. So why aren’t we all searching for a better way to play passive?
What about a US index tracker with just the good companies – can I have that, please?
So here is my Christmas wish list:
Dear Santa,
I would like a low-cost multi-index fund free from the clag of expensive active fund managers, holding only companies with good growth prospects, sound fundamentals, good management, and a competitive future-proofed advantage. I’d like these to sit in investible indices so that passive fund managers can control the strategic asset allocation. However, I don’t want stock selection. That would make my dream portfolio Active, so I’d just like a simple screen led by ratios to strip the nasty or uninspiring companies. In short, the primary benefit of passive investing to me is diversification and an acceptance that markets are efficient. I’d like this to be retained in enough of a sense to stay passive in my dream portfolio, to keep cost-effective, but to move the exposure for the average passive investor into the more interesting corners of the index—perhaps those that have historically driven returns.
Thanks.
I fear, however, that what I have built above may just be an Active Fund, and on its launch date, perhaps we find ourselves back at the beginning of the debate, comparing this to Passive—for the next iteration of the debate! With an array of products approaching their 5-year track record, allocators such as us need to be cautious of the question posed at the beginning: When does Passive become Active? The line is blurry.
Speak to the team
If you would like to discuss passive or active investment with the team at EWM Financial Planning, get in touch!