Active vs Passive management

Jonathan Willcocks, managing director global sales at M&G and Nick Blake, head of retail sales at Vanguard Investments UK, square off.

The case for active management

Jonathan Willcocks, managing director global sales, M&G

One of the most keenly debated topics in the investment world, the active versus passive argument has yet to find consensus within the industry.

As part of a well-balanced and diversified portfolio, passive funds can have their place, helping to lower portfolio costs and adding diversification through exposure to different types of assets.

We are firm believers, however, in the benefits of active investment: using skilful stock selection to pick the winners, avoid the losers and build high-conviction portfolios.

Passive investing, in particular the use of exchange traded funds (ETFs), many of which track an index or market sector, has grown substantially over the past decade in terms of inflows and the number of products available. Proponents of passive investment strategies believe it is very difficult, if not impossible, to beat the market; so you are better off simply tracking it.

This proposition may be acceptable for many investors during a rising market, but index-tracking funds look much less attractive when markets are falling or moving sideways. Instead of sitting back and watching your returns evaporate in a downturn, why not entrust a skilled manager to seek out the strongest companies that are best placed to weather the difficult times and preserve value for investors?

Advocates of passive strategies would argue it is extremely difficult to find managers with such skills, and even harder for those managers to deliver outperformance year after year. They would also point out that total expense ratios (TERs), combined with poor management, have resulted in very few active funds outperforming their benchmarks over the long term.

But these arguments ignore the fact there is a large number of active fund managers who have proven their ability to outperform the market – after fees – over long periods. The M&G Recovery Fund, for example, has outperformed the FTSE All-Share index net of fees in each of the nine calendar years since Tom Dobell took over as manager. (Source: Morningstar as at 30.10.09, net income reinvested, based on Sterling Class A Shares.)

Companies offering passive products further argue that returns from active funds are largely driven by the market (beta returns), so investors should not pay fees to access this. But even index trackers incur a cost, so an index fund will always underperform after fees have been subtracted from returns. However small the fees are, they will add up over time, eating into gains.

What is more, many indices track the capital appreciation of shares only, rather than their total returns. Investors in tracker funds that follow these indices therefore miss out on dividend income, which is a big part of the returns from equity investment – especially in falling markets when capital gains are harder to come by.

Passive funds are much more constrained than actively managed products. They are forced to buy index constituents at market price, whether or not the shares are a good investment. In this way, passive funds are obliged to chase sentiment-driven share price bubbles all the way to the top and down again.

During the TMT bubble of 1999 and 2000, for example, Vodafone shares skyrocketed to the extent that the company made up 13% of the FTSE 100. Index trackers had no choice but to buy Vodafone even though a bubble was forming. Active managers could choose to avoid it, protecting investors’ money as the bubble burst.

In the same way, index trackers are forced to hold market weightings in certain sectors, which can distort diversification. Financials, for example, made up a large proportion of the FTSE All-Share Index before the credit crisis. Index funds that held this full weighting were left extremely bruised when bank stocks crashed. Active managers can elect to underweight a sector or avoid it altogether if they have a negative outlook for it.

Therefore with thorough analysis, a long term investment horizon and identifying irregularities in the market, we believe it is possible to achieve higher returns with active management, greatly enhancing investors’ returns and outweighing higher fees.

The case for passive management

Nick Blake, head of retail sales, Vanguard Investments UK

The rise in popularity of index management in an active management world is often presented as a binary battle of beliefs. Indexing champions are unequivocal in their choice of index management, citing the challenges faced by the active community. Active managers are confident in their ability to add value through security or sector selection.

Traditionally, the core argument in support of indexing questions whether active managers can possibly achieve consistent delivery of alpha through stock picking and market timing. Not only is it hard for the active manager to get it right, it is even harder for advisers to consistently pick the successful fund managers in advance.

The evidence would support the indexers’ case. Over the past 20 years, 85% of UK equity managers failed to beat the FTSE All Share index, with 69% and 72% failing to beat it over three and five years respectively. (Source Morningstar at 31.12.2008.) Interestingly, over 10 years, an almost acceptable 49% of managers did manage to beat it.

However, a more granular look at these percentages shows there are a higher number of returns grouped around the mean index performance. A return difference between 0-3% was very often the difference between winning and losing for many managers. This highlights the main challenge to active managers – costs. Creating alpha in the first place is hard enough. Keeping it after the application of costs is even more difficult. Many active managers may have produced an index-beating return had it not been for fund costs dragging their result back below the waterline.

Before costs, the stock market is a “zero-sum game.” For every investor who outperforms the market, another investor has to underperform. In aggregate, investors are unable to beat the market because they are the market – half of investors will win, half will lose. Yes, there are winners, but a bit like a casino, the house always takes a percentage.

In fund management, the whole market return available is reduced by fund costs. For 2008, Lipper reported average total expense ratios (TERs) of 1.66% for active funds. In real money that was approximately £4bn of costs that did not reach clients’ accounts. That number would be bad enough if it was the full story, but it is not.

The irony of a TER is that it does not represent the total cost of running the fund. It ignores the transaction costs and taxes incurred each time an asset is traded within the fund. The transactional costs of a high turnover active fund can easily double the apparent TER and destroy value. This is why the zero-sum game is sometimes referred to as “the loser’s game”. The total return is not available to the players, so collectively they lose.

Some would have us believe the efficiency of the market concerned makes a difference. It is argued that indexing works best in efficient markets where it is hard for the manager to out-think the market and that a good active manager can excel in inefficient markets where local knowledge may tell. In fact, there is no empirical evidence that either is true. In many cases, more inefficient markets cost more to access, thus increasing costs and offsetting the perceived alpha opportunity. One thing is certain; both are “loser’s games” as costs hurt performance.

So index champions would seem to have a simple argument. It is not what you get, but what you get to keep that really matters. Achieving the average return, and keeping it is the way to go. The way to win is not to lose. It is a strong case, but active managers should keep heart. Active management has its place, perhaps to de-correlate a portfolio, or access a theme that may not be available through an index strategy. Many advisers are meeting clients’ primary goals with a core index strategy and spending excess risk budget on alpha.

Outperformance is not impossible to achieve, but is certainly more attainable from those active managers with great processes operating at low cost. The binary active versus passive debate has not seen a winner emerge since it started. That is because active versus passive is the wrong debate. It is costs that matter more.