Is passive funds management a mistake in the post GFC environment?

Active versus passive is one of the oldest debates in funds management. However, Tyndall's Craig Hobart warns those who have embraced passive strategies in the aftermath of the global financial crisis might find that their strategy could prove entirely counter-productive.

The reported increase in passive investing in recent years has largely been linked to the protracted market downturn with investors flocking to the perceived safety of the index in the aftermath of the global financial crisis (GFC).

But this decision can be precisely the wrong tactic during such periods.

Choosing whether to invest with an active or passive manager really shouldn’t be about trying to time the market.

In our view, this is difficult to get right and even if you do, the tax implications of repeatedly changing strategies are likely to outweigh any benefits.

Nor should the decision be based purely on headline performance numbers or fees. Rather, other considerations such as risk, a fund manager’s adaptability and shareholder activism should be factored into the decision-making process.

There are marked differences in how active and passive investors manage these issues, which can have a direct impact on an investor’s total risk/return outcome.

The key really comes down to choosing the right manager for your needs - and that isn’t necessarily as difficult as you may think.

Index investing can mean higher ‘real’ risk

Not surprisingly there has been a focus on the role of fixed income in a portfolio following the GFC, with many mortgage funds experiencing a lack of liquidity and some fixed income products delivering significantly negative or equity-like returns.

Many investors trying to squeeze higher returns from a fixed income allocation learnt the hard way that the trade-off for higher returns does actually mean higher risk.

And to add to the pain, unfortunately in the early stages of the de-risking process during the GFC, many investors sought the safety of passive investing, perceiving credit securities to be too risky.

The only problem with that, of course, is that at that time many bond indices had high exposures to credit securities (as shown in figure 1) — so investors weren’t necessarily escaping from the bad credit.

This raises one of the biggest downfalls of passive investing in fixed income. When a company issues more debt, the index weighting for that company increases.

Of course, the more debt a company issues the more questionable its financial security can become, so the real risk of passive fixed income investment changes over time as companies and governments adjust their funding requirements.

While an active manager can make an assessment of the credit worthiness of an issuer and therefore choose (or not) to take on additional risk within a portfolio, the passive investor can’t.

As a result of the market fallout, the focus has moved away from maximising returns from a defensive allocation to a risk-based approach.

This raises a problem for passive investors though, as the decision to allocate up and down the risk spectrum is dictated by the issuers, which has a direct impact on the risk profile of the index (as highlighted in figure 1).

This is not a tactical or short-term issue specific to 2010, rather a longstanding problem with passive fixed interest investments. This begs the question: is any change in the risk profile of the index in line with a change in investor needs? The answer is of course, no.

What most investors actually need from a defensive allocation is income and a negative correlation with equities.

An active fixed interest manager can offer these - but how can a passive manager commit to offering these when the investments held in a passive portfolio are at the whim of banks and governments rather than investment professionals?

Active management can work in all seasons

As mentioned earlier, timing the market between active and passive strategies may not be a wise strategy. It can be a high risk and tax ineffective approach for individual investors.

However active managers do have a natural advantage in that they are able to adjust their portfolio in response to the market such that when there is a large dispersion of potential returns from firms (as measured by the P/E ratio), tracking error in active portfolios will be higher as the manager puts the research to work to take advantage of an increased investment opportunity set.

Conversely where there is relatively little to separate stocks from each other, tracking error in active portfolios naturally reduces, as there are fewer opportunities to generate alpha.

This seesaw effect is illustrated in figure 2, which shows that as the P/E dispersion of the S&P/ASX 200 Index has risen, so too has the tracking error of the Tyndall Australian Share Wholesale Portfolio. Similarly, as the market’s P/E has contracted, so too has the Fund’s tracking error.

Thus in a sense, active portfolios are self-correcting, lying in wait of active opportunities during quiet times and pouncing on them when they arise.

The question is: Who is better to decide when is the time to pounce? Is it an investor who has switched to a passive strategy, or the portfolio manager? We would argue the latter.

Active investors can benefit from being activist shareholders

Another advantage offered by active managers is their ability to take a larger than index weighting in, which allows them to take positions in stocks that are likely takeover targets.

In addition, their in-depth research capability means they are better placed to negotiate an optimal price in merger and acquisition deals.

Active managers are better equipped to understand the underlying value of a company and are therefore better placed to negotiate a more optimal price outcome - to the benefit of their underlying investors.

Equally they can also pressure boards not to proceed with poor acquisitions.

Picking the right manager is the key

Active management has a lot of merits, and the decision to choose active versus passive is not as straightforward as often perceived.

While it is inevitable that some active managers will underperform their respective indices at points in time, it is worth mentioning that a significant proportion also outperform - highlighting the point that the active/passive debate ultimately comes down to manager selection and personal preference.

Selecting the right active manager is key, but not necessarily difficult. There are examples of where choosing highly rated funds can generate significant outperformance.

For example, the van Eyk managers rated A and above in Australian equities have consistently outperformed both the median manager and the index over the last 17 years (see figure 3).

Using these ratings, along with assessing the true level of risk as well as a fund manager’s flexibility and adaptability in different stages of the investment cycle, are extra tools investors can draw on when choosing an appropriate investment style — rather than relying solely on headline performance and fees.

Craig Hobart is the acting chief executive of Tyndall.