London: Active managers and those who promote their wares have two main responses to the academic evidence and the passive cohort.
One is that passive investing is not the land of milk and honey. For a start, it is not always as cheap as it seems. True, UK investors can buy a FTSE 100 or S&P500 tracker that charges just 0.07 per cent a year. But there are still tracker funds (often run by, or on behalf of, banks) that charge 1 per cent — more than many actively managed funds. Venture away from the headline indices and costs quickly escalate. The cheapest emerging market tracker costs 0.25 per cent, but most cost more than 0.4 per cent. Many specialist funds charge 0.5 per cent or more. To that must be added the costs of transacting on a suitable platform.
Almost all of the world’s major stock indices are weighted by market capitalisation. That means passive investors are effectively buying companies whose market values have already risen the most — the opposite of “buy low, sell high”. They may also be unwittingly overexposing themselves to particular regions or sectors. A fifth of the FTSE 100 is oil, gas and mining. Chinese shares traded in Hong Kong constitute about the same proportion of the MSCI Emerging Markets index. Yet many investors have little idea how indices are constructed, weighted and rebalanced.
Passives also do not lend themselves to certain asset classes. You can buy a passive property fund, but it will contain shares in real estate investment trusts whose performance may correlate more with that of other shares, not physical property. Any asset class where liquidity is limited may often be better served by active management — preferably in a closed-ended vehicle.
But the main charge against passive is that after costs, investors are doomed to underperform. Mathematically that is beyond dispute, yet the degree of underperformance depends on more than just management costs. Passive investment vehicles frequently do not own all the stocks in an underlying index, or they may use derivatives to imitate the returns. All this results in tracking error, which is a bit like portfolio turnover in active funds: hard to discern, and so widely ignored.
Investors in passives still have to make asset allocation decisions, such as what proportion of equities to bonds, or whether to tilt more towards emerging markets than developed ones. Critics say it is as easy for a passive investor to get this wrong as it is for an active manager to mess up stock selection.
Ken Fisher, a US wealth manager (and FTMoney columnist) argues that investors rarely have the patience to make passive investing work in practice. He cites a famous 2009 study that found the average holding period for a fund was 3.2 years. “To do passive right, you can’t sell your funds and change your strategy every 3.2 years,” he wrote in Debunkery, his 2010 book.
There is an obvious retort to the failure of the average active manager to beat an index: do not invest with an average manager. Find an above-average one instead.
They certainly exist; not just famous names like Mr Woodford, Axa’s Nigel Thomas, Aberdeen’s Hugh Young or Fidelity’s now-retired Anthony Bolton, but unsung heroes such as Daniel Hanbury at River & Mercantile.
There are two problems with hunting out star managers. One is that they may not outperform consistently. Not all investment styles will work well in all market conditions and even the most successful funds or managers have endured bouts of underperformance, sometimes quite long ones. The M&G Recovery fund, which has an unusually long performance history, has disappointed in recent years. Harry Nimmo’s Standard Life UK Small Cap fund, long regarded as one of the sector’s leaders, is also in a lean patch.
The danger is that investors, lured by past performance, may buy just before a slump, or lose faith just as performance is about to recover. Managers may also retire, defect to other fund houses or sometimes just decide they’ve had enough; last month, Julie Dean unexpectedly quit as manager of the highly-regarded Schroders UK Opportunities fund.
— Financial Times
