Thoughts on the Active vs. Passive Debate | BetaShares

Thoughts on the Active vs. Passive Debate

BY David Bassanese | 29 April 2015
Share
With the strong growth in index funds and exchange traded funds (ETFs) in the Australian marketplace in recent years, debate is again swirling on the benefits of active vs. passive investment management. Some commentators have suggested that index-oriented investments are merely for “dumb” investors, who have no real skills in picking mispriced securities likely to outperm the market.  If this were to be true, it would follow that these investors are leaving money on the table as by either investing in the development of these skills – or hiring talented active managers – they could produce better returns. It has been suggested that over the very long run, “sensible investing” in “quality” stocks “will beat an index”. How true is this? (spoiler alert: the evidence suggests this is not true!). This note offers some perspectives.

SPIVA

The evidence suggests most active managers can’t and don’t outperform the index

Fortunately for participants in the perennial active/passive debate, whether active managers can outperform a market-cap weighted index is ultimately an empirical question.  On this score, the evidence seems overwhelmingly in favour of passive investment – both in Australia and overseas.  According to the latest SPIVA Australia Scorecard by S&P Dow Jones Indices, charted above, for example, a full ~78% of active Australian general equity managers underperformed the S&P/ASX 200 Index over the five years ending December 2014.  The performance of local international equity managers, Australian fixed-income managers, and listed property managers was in fact somewhat worse. Over the latest 3-year period, the scorecard was slightly better for Australian equities active managers, although 6 in 10 managers still underperformed.

Even if active managers were able to consistently outperform the market, moreover, their degree of outperformance would need to exceed their management fees to beat some of the very low cost ETFs and index funds available.   As but one example, a fund that charged a 1% p.a. management fee plus a 10% outperformance fee would need to generate a return of 10.95% p.a. to offer the same return to an investor in an index product that rose by 10% in the year and charged a management fee of 0.15% p.a.

Of those active managers that do outperform over a certain period, such outperformance is unlikely to persist

Of course, the above evidence suggests that some active managers can outperform the market.  The only challenge investors face, therefore, is in identifying these superior managers.  The problem, however, is that actually picking active managers that consistently outperform is not as easy as it seems.  As the old truism goes, past performance is not a great indicator of future performance.
The chart below, for example, is based on research on Australian active equity managers from Mercer Consulting which tracked the performance of investment managers across two three-year investment periods.  The question is: how many of the funds that performed well in the first period also performed well in the second period? In other words, how persistent was outperformance?

As seen in the chart, it turns out that only 24% of the 29 funds identified by Mercer as enjoying top quartile investment performance in the three-years to September 2010, were also able to produce top-quartile performance in the three-years to September 2013.  In fact, statistically speaking, the most likely scenario (31%) is for a top quartile performer in the first period to end up becoming a fourth quartile performer in the second period!  Meanwhile, almost one in five of these top performing funds ceased operation (or were merged/taken-over) in the second three-year investment period.

spiva2

Indeed, according to the Mercer Survey, of the 32 funds with top quartile performance in the three-years to September 2013 (among 126 funds covered), 16 – or 50% – of these funds were new to the market.

spiva3

As they dominate the market, it’s hard for all active managers to outperform all of the time

Due to the fact that institutional money – which is still predominantly active in nature – tends to dominate ownership and therefore trading in the Australian equity market, it stands to reason that not all managers (who effectively “are” the market) can outperform the market all of the time.  This is because for every ‘winning’ trade, there will equally be a ‘loser’ on the other side. As seen in the chart below, of the $1.6 trillion worth of “listed and other” equities in Australia as at end-December 2014, a whopping $1.4 trillion – or 83% – was owned either by domestic insitutional investors, or foreign owers (which are also largely institutional).  Households directly owned only around $200 billion, or 13%.   With active managers owning around 80% of the market, their collective attempt to beat the market is akin to a zero-sum game.

spiva3

Exchange Traded Funds can do more than just track market cap-weighted indices

It’s also important to know that, due to the development and continued innovation in indexation – there are now a number of indices which recognise the limitations of traditional market-cap weighted indices, including some offered by my firm, BetaShares. These ‘smart beta’ indices, such as, for example, fundamental weighted indices, combine the benefits of index funds (i.e. low  cost, transparent, diversified, rules based) along with the potential to outperform the market-cap benchmark.

We’re a long way from passive investment distorting the market

There has been some conjecture that the continued growth of index investing and ETFs may contribute to potential market distortions. Truth is, we’re a long way away from that. According to Morningstar Research estimates, passive investment strategies have accounted for around 8% of the Australian managed funds industry in recent years – at these levels its unlikely rebalances in such products will be a major influence on market pricing.  With only ~$18 billion funds under management, moreover, ETPs account for only ~0.7% of the $2.4 trillion managed funds industry as at March 2015.

That said, even in the United States – where passive investment is estimated to account for a much larger 24% of funds under management in 2013 – it still seems evident that active managers have a hard time beating the market.  According to S&P’s latest survey, for example, 88% of large-cap US managers failed to beat the S&P 500 index in the 5-years to end-2014.

With all that said, there is no doubt that there do exist a select number of active managers who have a strong track record of persistent outperformance. At BetaShares, we firmly believe that active management has a role to play in investors’ portfolios, and often find ourselves discussing how ETFs can be used in combination with high quality active managers. However, when considering the active vs. passive debate, we believe it’s important to be armed with the empirical facts.

19 Comments

  1. Bruce  |  April 29, 2015

    David, many thanks. May I have a copy that i can print. Bruce

    1. BetaShares  |  April 30, 2015

      Bruce,
      Yes, of course. We will send it to you via a separate email

  2. Gary  |  April 29, 2015

    The ASX200 is continually changing anyway, e.g. the 200 of 2015 is different to 2010 – so you can actually argue that the Top 200 is actively “adjusted” and is not passive at all . This also explains why over time the stockmarket “always goes up” … as the poor performers are continually weeded out … survival of the fittest … Darwin would be proud methinks.

    1. BetaShares  |  April 30, 2015

      Hi Gary,
      We certainly wouldn’t argue with that! The rebalancing that takes place in indices is absolutely!

  3. Allan  |  April 29, 2015

    I think this is good article. However the problem for us is to identify those good managers & how to blend them with products such as yours. We have a fairly large sum invested and would welcome that service in the long run as much of our money is destined for grandchildren.
    I’m also critically interested in further investing in the Chinese market so we r well positioned as their market grows. Also believe their currency will become a reserve currency this October meeting of IMF or soon thereafter so would like to invest in their mkt in their currency somehow.

    1. BetaShares  |  April 30, 2015

      Allan,
      As this article indicates, it is indeed very difficult to find active managers that consistently outperform, which is why a lot of clients use passive investments such as ETFs as their investment core and then find high quality satellite managers to fill out their portfolios.

      As for China, thanks for the product suggestions, we’ll feed it back to our product development team

  4. In reality, the vast majority of active managers are only active in marketing. Most are in the business of product manufacturing and they dominate the industry. In this regard, a more accurate classification on the majority of ‘active’ managers would be “enhanced index”. Unsurprisingly, the result (after allowing for higher fees charged) is chronic and persistent under-performance against the market benchmark.
    Analysis on a set of managers that are filtered for ‘active’ legitimacy, would be more relevant and of greater interest. I suspect that such analysis would present a shade of grey to to the above (black & white) findings.

    1. BetaShares  |  April 30, 2015

      We’d love to see such research but certainly haven’t come across it ourselves!

  5. Chris  |  May 1, 2015

    Can you also provide me with a printable copy please

    1. BetaShares  |  May 1, 2015

      Yes of course – will send through separately

  6. Peter  |  May 1, 2015

    To be absolutely fair, you should compare the outperformance of active managers compared to passive managers after fees, rather than to the index. The latter is an ideal which can never be reached because every fund has transaction and administration costs whereas the index is cost free.

    1. BetaShares  |  May 1, 2015

      Peter,
      That’s a fair comment but we haven’t seen any longstanding research which does this. That said, with simple passive ETFs tracking well known indices (such as the S&P/ASX 200) the fee levels are very small indeed.

  7. George  |  May 2, 2015

    Is a printed copy available?

    1. BetaShares  |  May 4, 2015

      Hi George,
      Yes, of course. We will send one to your email address

  8. Christina  |  May 28, 2015

    Could you please send me a printable copy of this article. Very informative.

  9. Christina  |  May 28, 2015

    Please send me a printable code. thank you

    1. BetaShares  |  June 3, 2015

      Sure Christina, it’s on its way to you now

  10. Patrick  |  October 8, 2015

    Interesting article David, and I agree on some points, though not all.

    You said:
    “Even if active managers were able to consistently outperform the market, moreover, their degree of outperformance would need to exceed their management fees to beat some of the very low cost ETFs and index funds available. As but one example, a fund that charged a 1% p.a. management fee plus a 10% outperformance fee would need to generate a return of 10.95% p.a. to offer the same return to an investor in an index product that rose by 10% in the year and charged a management fee of 0.15% p.a.”

    Unless you’re quoting before-fee returns (which would be very strange) this would not be true. Most managers in Australia quote their returns after fees – in fact it is the fees that usually drag the ‘average’ managers to below-market returns.

    3 years is nowhere near long enough a time period to be looking at, 5 years is an absolute minimum to get any indication, and Fama and French have suggested that to get a reliable indicator you need longer than this.

    I think we can both agree however, that there are active managers who can consistently outperform the index (as Warren Buffet taught us with his Superinvestors of Graham and Doddsville speech in ’84), the difficult part is identifying in advance who they might be! Past returns are not a good indicator, but other factors could be.

    Some of the factors which I think show potential (though their reliability is questionable, and I think they need further investigation) include ‘active share’, portfolio concentration, a value bias, a small-cap bias, and portfolio turnover. I’ve seen research on each one of these factors which suggests that in isolation they are indicative of the potential to outperform (of course a ‘closet index’ fund is never going to outperform, especially after fees), however they cannot be relied upon to predict fund performance. My own expectation is that, when multiple boxes are ticked, one may be able to produce a more reliable indicator of fund performance.

    Of course this is just my hypothesis at this stage, I hope to do some proper research on the subject in the final year of my Master’s degree.

    1. BetaShares  |  October 11, 2015

      Thanks for your comments Patrick, very thoughtful.

      Note that over 5 years the numbers are usually a fair bit worse for active managers (after fees) as compared to their passive benchmarks.

      Best of luck with your Masters

Leave a Reply