Parliamentary Session: Active vs. Passive

Until mid-February, global stock markets were treating COVID-19 as a problem for China. Since the virus leaked out, many more countries shut down their economies to contain it and as a result, share prices suffered dramatic declines. This turbulent period brought certain debates back to centre stage, including one of the most prominent arguments of the last Bull market. The competing value of active against passive investment.

Passive funds are designed to rise and fall in lockstep with an index (like the FTSE 100). This is the opposite approach to active investment, which involves a more hands-on approach (and higher fees) in the hope of outperforming the wider market.

Over long periods preceding this crisis, evidence revealed that active managers were not beating the market (net-of-fees). As a result, the industry watched a tidal wave of investment flood away to passive strategies. Traditional managers have long blamed the Bull market for their underperformance, claiming they would really shine when markets turned south. This should be their Olympic moment.

In fact, during the recent downturn there’s growing proof that many active managers got slammed even harder than their passive benchmarks¹. Whilst this conclusion can vary slightly, depending on the source, the fact that the group’s performance broadly followed the index is revealing.

Investors pay active fees because they expect outperformance or area-specific expertise, so questions should be asked of the managers that still tracked the index. Active management involves expensive research, which is supposed to constitute a strategy’s ‘secret sauce’. But, if the performance is almost totally correlated with the market, then retail clients are only paying for generic market exposure. Something they could easily achieve by passive investing and at a much lower cost.

Whilst index funds have blown a great big hole in the traditional business model, functioning markets need this active management. Collectively, these teams engage in price discovery, keeping equities closer to a relative fair value. They are often the ones buying into share price weakness, helping us by acting as a natural floor. This research is expensive work to undertake and many feel their passive competitors are making huge money by hitching a free ride on their coattails.

Like political parties, dyed-in-the-wool members of one can’t abide one another, however, us true countrymen want the best outcome, regardless of tribe. So take a seat, parliament is in session.

The Case – Active Management

We the people demand outperformance, and to get it we must play a zero-sum game. So, if we expect to beat the market, then who is going to be on the losing side of our trade? Quality active managers can discover mis-pricings, giving them (and us) an upper hand in markets where greater numbers of these abnormalities exist.

For example, look toward Emerging Markets, which has higher volatility, less developed financial institutions, and considerably more retail participation. In South Korea and India, upward of 45% of trading is currently done by individuals. In China, almost 90% of trades are placed by non-professional, retail investors².

That’s the opposite of what we see in developed markets where 5-10% of trading is done by individuals and sophisticated, institutional or professional investors are more likely to be on the other side of our bet. Developing markets can offer greater reward because less sophisticated investors suffer greater behavioural biases. More emotional decision-making means more mis-pricings. Investors should make good use of this.

The best active strategies are systematic, transparent, and reasonably priced. Within that framework, disruptive events like the current pandemic create unique and interesting opportunities. Active strategies, if built correctly, are still best suited to capture them.

The Case – Passive Management

The passive index fund is the most successful financial innovation in modern history. No question.

It is notable however that passive pioneer, Jack Bogle wrote that it would not “serve the national interest” for index funds to own more than 50% of the stock market (half of funds and ETFs are already passively managed). At which point, their impact starts to become too big for the market’s good³. That’s because, the thinking goes, an efficient market only works if there are both buyers and sellers, who hold different opinions on a share’s value. This breaks down when there is no one on the other side of the transaction, and no one is doing active research to uncover information about companies’ true worth.

For investors, total market exposure is crucial. Over the last 90 years, roughly 4% of US stocks accounted for all that market’s net wealth creation. The remaining 96% collectively generated gains that just matched the return on Treasuries over that period. Incredibly, only five stocks (Exxon Mobile, Apple, Microsoft, GE, and IBM) accounted for a colossal 10% of all that created wealth⁴.

The point being, you need to have total market exposure to avoid missing an Apple, an Amazon, or whatever the next behemoth of the future will be. What you do not need is an active manager to provide it. It’s an (almost) free lunch, so don’t overpay for it.

Passive strategies are evolving. Investors should include the more sophisticated products now available. Most are still built on the same model originally developed in the 1970s, which rebalance on the market cap (ie: size) of each share in the index. Newer, multi-factor strategies can be made to work even harder by tilting toward stocks with favourable characteristics (e.g: cheap stocks, low-risk stocks, stocks with wind in their sails, etc). This has been seen to boost performance and achieve better diversification, whilst maintaining incredibly low costs.

“ORDERRR!”

Since the Global Financial Crisis, ultra-low interest rates and a massive increase in the money supply have helped reduce the downside risk of stock investing, so far.

In this ecosystem, the traditional business model of active managers has suffered increasing pressure. The attack on their value proposition will not get any easier as investors focus on the attractive net-of-fee performance, and growing sophistication, of passive management.

As we close this parliamentary session, investors can draw out the following lessons:

• Lesson 1:  Don’t pay active-level fees to obtain passive-type performance.
• Lesson 2:  Make low-cost passive investments your portfolio’s bedrock. Get these working as hard as possible by using multi-factor strategies built around factors other than standard ‘market-cap’. This will ensure you can’t miss out on the next big thing, or be wiped out by the next big flop.
• Lesson 3:  With a diversified foundation in place, use active management to take conviction in more aggressive investments, or tilt the portfolio towards certain geographies or themes.

With that, “UNLOCK!”

Endnotes

¹Financial Times; 2020 Stockpickers failed to take ‘big chance’ in market rout

²Phillip Wool; 2019 Making the Case for Localized Quant Investing in Emerging Markets

³Wall Street Journal; 2018 Bogle Sounds a Warning on Index Funds

⁴Bessembinder; 2018 Do Stocks Outperform Treasury Bills?