Active versus passive funds - is it time for a new perspective?

Robert Keavney considers the active versus passive funds management debate and concludes that both sides’ arguments are too simplistic.

I enjoyed Robin Bowerman’s contribution (Performance Anxiety, October 1, 2009) to the debate about active versus passive management, especially his conclusion that it is a matter of combining them rather than “one way at the exclusion of another.”

It was a relief to have an index manager discuss this subject on practical grounds (ie, that it is hard to identify superior active managers, so low cost should be a major factor) rather than building a case based on the efficient market hypothesis (EFH).

The EFH provokes strong feelings. Some advocates treat it as though it is the one true religion, and all others ideas are blasphemous. Some on the other side are equally fanatical, including the broker Bowerman quoted who claimed indexing was ‘un-American’.

One fact that all participants in this debate surely agree about is that it is difficult to outperform a market index — and few active managers do so consistently.

This is a matter of historical record. The average fund manager will achieve average returns before fees, just as the average lawyer and the average plumber will produce average quality work.

As, on average, active funds will match the market before fees, it follows that most will underperform after fees. Index funds also underperform after fees (something they fail to mention, despite their focus on the fees of active managers) but by a smaller margin, because their fees are lower.

Therefore index funds will do better in the long run than the average active manager.

Of course, no planner intentionally selects average managers to recommend for clients, though many find out with hindsight that they have done so. It is difficult to identify superior fund managers; few people have this skill, and those who do still make mistakes.

This is the central case for indexing, and it has merit.

However, this does not prove that no fund will generate superior returns or that no one can identify superior funds. Often, this debate sinks to the level of asserting or denying that active funds add value. The demonstrable reality is that while most won’t, some will.

And some do have reasonable success in identifying them in advance. Graph 1 compares the performance of the international equity trusts on the Approved Investment List of Centric Wealth (disclosure — my employer until a year ago) with the MSCI since 1991.

Efficient market hypothesis

Many index funds have done themselves a disservice by promoting themselves on the grounds of the efficient market hypothesis. It has been self-serving in that it provided a justification for advisers placing 100 per cent of a portfolio in their hands as, according to the theory, any inclusion of active managers is ‘diworsifying’.

However, planners who find the hypothesis absurd have tended to be repelled by index funds — despite their cost advantages.

The theory has always been full of circular arguments such as ‘the market price is always the correct price’. If you enquire what the meaning of ‘correct’ is you learn that the correct price is always the market price.

This tells us that the market price is the market price and the word ‘correct’ has no meaning beyond that.

It certainly doesn’t mean ‘sensible’ or ‘the price you should always be prepared to pay’, because there have been so many cases of patently absurd stock prices.

Take the price of CDOs at the peak of the recent bubble. Are we to believe that none of them were ever over-valued, not even by one cent for one day?

Or take my favourite example from the era of dot.com madness. A listed business, though I use the word charitably, named NetJ.com Corp was a model of good governance in its full disclosure, reporting to the US Securities and Exchange Commission that:

“the company is not currently engaged in any substantial business activity and has no plans to engage in any such activity in the foreseeable future … [It has] extremely limited assets … no source of revenue”.

Although NetJ.com had nothing of value and did nothing of value, its market cap was in excess of $30 million, and had risen by around 700 per cent in a little more than six months. This was not the correct price — this was stupidity! The idea that this stock was efficiently priced is laughable.

Purist efficient market hypothesis denies even the possibility of consistently producing alpha. An article of mine on this subject appeared in Money Management in September 2004, which contained:

“Those who believe no one can consistently beat a market (and its amusing corollary — no one can consistently fail to match it) need to explain the inconvenient fact that, at any point in time, some managers will have done better and some will have done worse.

Over the short term, chance will have influenced this. It is much more difficult to explain away sustained superior returns as luck.

For years I have tabled the performance of Kerr Nielsen and his team as a demonstration of superior skill.

Hardline efficiency junkies pass this off as, in principle, unsustainable. My response is that they argued this years ago and, lo and behold, it has been sustained.

If they remain superior for, say, the next five years can we consider the debate closed?”

Conveniently, five years have now passed since this was written and the results are set out in Table 1.

Can we now consider the debate closed? Or will this again be passed off as luck — amazingly sustained ‘luck’ overlayed with my ‘luck’ in picking Platinum, among all the possible funds in Australia?

The Platinum team has massively outperformed the market for around a quarter of a century, including more than 14 per cent pa alpha over the last decade — surely enough to qualify as a demonstrably superior active manager.

While it is generally difficult to identify superior fund managers in advance, surely the team at Platinum is such a case today (the team is superior, not Platinum itself — because skill is almost always dependent on key people).

Any equity fund which has generated say 2 per cent pa excess return over at least a full cycle, but preferably even longer, without material changes to process or key personnel, is at least worth researching as a candidate.

In my view Tyndall is a high quality Australian equity manager with a demonstrated ability to generate long-term alpha — more than 2 per cent pa over the decade to September 30 after fees.

Sustained material alpha with stable personnel and process is the best criteria for considering a fund.

This is at odds with the common practice of being attracted to a manager who has done well for the last year or so and gives a good presentation.

Applying this criteria would reduce the universe of candidates to quite a short list. I do not suggest that this is the only criteria for recommending a fund, nor is it alone a sufficient condition, but it provides a discipline against ‘gut feeling’ and the risk of being persuaded by a charismatic presenter.

Planners would do better using index funds than selecting managers using this sort of process.

It goes without saying that everyone will underperform at times — sometimes for a couple of years. Anyone who is tempted to abandon a fund whenever this occurs will again be better served by index funds.

Which index?

All discussions on index funds refer to ‘the market’, creating the illusion there is an objectively identifiable entity called ‘the market’ — the performance of which index funds reflect. There is no such entity called ‘the market’, merely a group of stocks selected on some basis, which is usually (but not always) size.

Which one of the ASX50, ASX200 or ASX300 reflects ‘the market’?

Most index funds are cap weighted (ie, the stock with the largest market cap is most heavily represented in the index).

By contrast, the Dow Jones Index is price related. This means that if company A falls by 1 per cent of its price which happens to be a fall of $1, and company B falls by 50 per cent of its price which is also $1, they would have the same effect on the Dow — irrespective of the market cap of A and B.

To many people this is a strange sort of index. Nonetheless, the funds that track it are undeniably index funds.

Clearly the Dow will, at times, underperform ‘the market’ if we consider the S&P500 to be the market, but the S&P will periodically underperform ‘the market’ at times if we consider the Russell 3000 to be the market, etc.

So the term ‘the market’ is subjective. Therefore indexing does not match ‘the market’, it matches a selected portfolio of stocks believed to be a useful benchmark.

Colonial First State’s Realindex funds are creating a debate about cap weighted versus ‘economic footprint’ indexing.

Realindex invests in companies according to their size measured by book value, five years of sales, cash flow and dividends. Its argument is that cap weighting results in over exposure to over-valued stocks and under exposure to under-valued stocks.

For example, index funds had their highest weighting of financial stocks at a market peak in 2007 — because it was then that they were most over valued.

Thus Colonial claims passive investing combined with beating ‘the market’. It doesn’t select stocks on value, but buys large businesses irrespective of value. In so doing it seeks to avoid over-weighting into poor value.

Conventional indexers decry these concepts, claiming that they are not ‘true’ indexing but value investing — but here we face the reality that there is no universally accepted definition of indexing.

To some it must be cap weighting, while others claim the key attributes are reasonably broad exposure using a transparent, objective methodology with low turnover and low cost. According to these criteria, Colonial can reasonably describe itself as passive.

The definitions of ‘index’ and ‘passive’ are a matter of semantics. To my mind those who attempt to generate alpha have elements of activism.

Active and passive are not distinct and mutually exclusive categories. There is a spectrum of activism versus passivism.

It does seem that the moment any alpha overlay is introduced, the management expenses ratio goes up by more than any increased workload.

Even those who claim passivity feel it is appropriate to charge more for any purported added value.

This leaves conventional market cap indexers with the low-cost high ground, and the others claiming value for money and competing with active managers.

In any case, there are asset classes where the potential to add value is sharply limited. An example of this is bond funds, where even the best performer over any extended period generates only a fraction of a percent of excess return (eg, Australian bonds).

Few managers sustain any alpha after fees (though Roger Bridges of Tyndall is a consistent exception).

The case for indexing is strongest in asset classes where excess return is hardest to generate.

In my view real estate investment trusts are another area where the arguments for indexing is reasonable, though less so than bonds.

Passive investing hocus pocus

I believe there is a role for indexing in some assets classes, or for those without superior skills in manager selection.

But indexers do have a deplorable tendency to express meaningless clichés.

They claim to build ‘predictability’ into portfolios, by which they mean they will match an unpredictable market.

This does not make portfolios predictable in any meaningful sense.

The MSCI Accumulation Index has lost 2.6 per cent pa over the last decade. Investors in an index fund that achieved this are hardly likely to report that the fund’s return was delightfully predictable.

Indexers also claim that advisers ‘never have to say sorry’ about the performance of an index fund. Bunkum!

If a planner’s clients are in a fund which falls 32 per cent while the index falls 30 per cent, any unhappiness the clients feel will not just be about the 2 per cent differential.

Their concerns would not be materially different if had they been in an index fund.

Finally, index funds that charge fees should stop failing to mention that they never match their index (due to the fees they charge). It is a small but important principle.

All change

Every major market slump seems to trigger a review of practices, in the hope of avoiding repeated mistakes. Some who had used direct stocks switch to managed funds, while some go the other way. Some who used active funds move to direct, and others go in reverse.

No single approach is the correct policy for all of the portfolios of all planners, which is consistent with Bowerman’s main thesis.

In any case the focus should be more on asset allocation than fund selection. When a market falls, even the best managers will decline with it — with the possible exception of Platinum.

For the record, I have no association with any fund managers referred to.

Robert Keavney became a financial planner in 1982, and has played many roles since then. He still believes financial planning can be called an honourable profession.