Active? Passive? Or chimpanzees? - BetaShares

Active? Passive? Or chimpanzees?

BY Benjamin Smith | 15 September 2021
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Active? Passive? Or chimpanzees?

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So you want to invest your money in stocks. You know about the benefits of diversification and want exposure to lots of stocks, but don’t necessarily have the time or expertise to select specific companies yourself.

Many people in this situation use investment managers to invest on their behalf. There are multiple benefits to this approach, including that investment managers:

  • are able to buy and sell stocks with low brokerage expenses
  • can hold hundreds of stocks and effectively manage their exposure to different business sectors and geographies
  • have years of investing experience.

Investment managers may operate funds which invest in a specific asset class, industry sector or geographic region (e.g. Australian stocks, U.S. technology stocks, global bonds). In some cases, you can access investments through investment managers that would be expensive or difficult to invest in directly.

Investment managers are usually categorised into two broad investment styles:

  • Passive managers aim to track an index, which is a portfolio of securities published by an index provider such as Standard and Poor’s (S&P), or Morgan Stanley Capital International (MSCI). Generally, indices weight the companies in the relevant index by their market capitalisation (or size), but some will apply other methodologies. Returns for passive funds are generally expected to be in line with the returns of the index they aim to track, before fees and expenses.
  • Active managers typically seek to beat their benchmark index, by selecting securities they believe will outperform.

A piece of the pie

The catch of this service is that investment managers charge a ‘management fee’. This is deducted from the amount invested in the Fund and is dependent on a number of factors.

Passive managers typically do little trading – portfolio turnover is low – which helps to keep expenses for most passive funds low. Given that a passive manager is not trying to outperform the index, they do not need to employ highly-paid analysts to research stocks, which also helps to keep costs down.

An example of a passively managed fund is the BetaShares Australia 200 ETF (A200), which aims to track the Solactive Australia 200 Index, an index of the 200 largest stocks listed on the ASX. A200 charges a management fee of 0.07% p.a.1 In contrast, an active manager spends a lot more time and effort in the investment process, typically employing analysts to try and get an edge.

Picture thoughtful, number-crunching, university-educated individuals who spend their days looking for good stocks to buy. They drink their coffee black (never tea), meet regularly with company CEOs and keep one eye permanently glued to the AFR home page. They can quote Afterpay’s stock price at any time (within a couple of cents). All of this with the goal of identifying good companies to invest in, to beat the index – and other managers.

The active manager puts in a lot of effort, and feels they deserve appropriate compensation. As such, they usually want a bigger piece of the pie than the passive manager. Additionally, if they succeed in beating the index, they may seek a portion of that additional return, known as a ‘performance fee’.

The result is an array of different fee structures and levels. Passively managed funds such as A200 can cost as little as a few basis points (a basis point being 0.01%). Actively managed funds, on the other hand, typically have a higher management fee, sometimes with an additional performance fee for those years when they outperform the benchmark index.

Over the years, fees can eat into investor returns.

The humble ape and efficient markets

Common sense dictates that if you pay more for a service, it should be better. Therefore, if you pay an active manager more than a passive manager, they should provide you with better returns, right? Well, maybe not.

In 1973, Princeton University professor Burton Malkiel claimed in his bestselling book, A Random Walk Down Wall Street, that “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” That is to say, a chimpanzee could select stocks just as well as our university-educated stock picker.

Pundits and academics alike have hypothesised that markets are ‘efficient’. This means that as soon as a new piece of information is released (like a company’s financial reports, or the impact of a global pandemic on sales), it is priced into the stock immediately by the market. It follows from this hypothesis that, if markets truly are efficient, it’s impossible to get a head start on the market and beat it, arguably making active stock selection a very difficult task.

What matters to an investor is the after-fee return their investment makes. In other words, for an active manager to justify their existence, the fund has to outperform its benchmark index after the manager’s fees are deducted.

So how do the figures stack up?

Unfortunately for active managers, the historic data is not good. The majority of active managers do not consistently outperform their benchmark index once fees are taken into account.

The SPIVA Scorecard is a robust, widely-referenced research piece conducted and published by S&P Dow Jones Indices that compares actively managed funds against their appropriate benchmarks on a semi-annual basis. SPIVA data indicates, for example, that large cap active funds have tended to underperform their respective indices over a five year period. Additionally, in Australia, only 13.7% of equity funds have outperformed the S&P/ASX 200 over the last 15 years2.

Aus equities vs S&PASX200

Data as at 30 June 2021.

Basically, beating an index is hard yakka.

Conclusion

If beating an index is so difficult, what is an investor to do?

You can persist in trying for outperformance, giving your money to active managers, who typically will charge you handsomely for the privilege.

You can try the ‘blindfolded monkey’ approach, selecting stocks at random, which will certainly be cheaper than employing an active manager (and possibly just as likely to succeed).

Or you can turn to the passive approach, with its relative cost-effectiveness, in the knowledge that while you sacrifice the goal of outperformance, you typically won’t suffer from underperformance of the index you are seeking exposure to.

Many investing greats such as Warren Buffet have recommended passive funds over active funds – it’s arguably better bang for your buck. Ultimately, different investors will have different views on the topic, and both active and passive investment managers can have a place in an investor’s portfolio.

Here’s a brief summary of the key differences in active and passive investment managers:

active vs passive


1. Additional fees and costs, such as transactional and operational costs, may apply. Refer to the PDS for more detail.
2. https://www.spglobal.com/spdji/en/research-insights/spiva/

13 Comments

  1. Daryle Mann  |  September 15, 2021

    Interestingly Warren Buffet is an Active Fund manger (Berkshire Hathaway).
    Why? if he doesn’t believe in that style
    perhaps it is because as we get old and grey we become passive.

    1. Benjamin Smith  |  September 16, 2021

      Hi Daryle,

      Great question.

      Buffet has stated that ‘a low-cost index fund is the most sensible equity investment for the great majority of investors’, and that ‘by periodically investing in an index fund, the know-nothing investor can actually outperform most investment professionals’.

      This does seem to contradict his own investment philosophy, but then again, Buffet is not like the ‘great majority of investors’!

      Cheers,

      Ben

  2. What about the mid and small cap space where 48% of active fund managers beat the index over 15 years? Their average performance is also over 60% better than index over 13 years, and that average includes all outperforming and underperforming fund managers.

    1. Benjamin Smith  |  September 16, 2021

      Hi Jason,

      While active managers’ track record tends to be a little better for mid and small caps, the majority of Australian Equity mid- and small- funds have still underperformed the S&P/ASX Mid-Small Index over the last 5 years (https://www.spglobal.com/spdji/en/research-insights/spiva/).

      We note that their definitely is a place for active managers in certain assets classes that might be more inefficient (such as small caps, illiquid assets and emerging markets). But when it comes to large, liquid markets such as US equities, the hunt for outperformance (or ‘alpha’) is very competitive.

      Cheers,

      Ben

  3. Alistair Burch  |  September 15, 2021

    What happens when there are no active managers and only ETF’s – how does the Efficient Market Hypothesis then work? Obviously the market cannot ve 100% ETF. But it can be 1% ETF. Where does the cross-over occur?

    1. Benjamin Smith  |  September 16, 2021

      Hi Alistair,

      This is a very good question, and maybe best addressed in a separate article. You are right, if there were no active investors, there would be little opportunity for price discovery and share prices wouldn’t move (in the most extreme cases). Markets would become extremely inefficient.

      Determining the crossover point would be a very difficult task, but we’d argue that as active management currently holds the majority of Australian investment assets (about 87% in March 2021- https://www.morningstar.com.au/funds/article/aussies-sink-more-into-passive-funds-than-act/213195), there is still plenty of room for price discovery.

      Cheers,

      Ben

  4. Audrey McIntosh  |  September 15, 2021

    Do Active Managers pass on more Capital gains to the investor than Passive Managers?

    1. Benjamin Smith  |  September 16, 2021

      Hi Audrey,

      Because active managers typically trade far more frequently than passive managers, they will often be making capital gains on a fairly regular basis. As passive managers will only trade infrequently (e.g. quarterly or semi-annually), they are less likely to realise capital gains. The gains still comprise a portion of performance, they are just unrealised gains that have accrued in the unit value of the Fund.

      Cheers,

      Ben

  5. William Roome  |  September 15, 2021

    It falls outside the scope of your very useful article, but, of course, markets are only efficient as long as there are many active managers/investors who do not believe the theory of efficiency! It is only the diligent search for new information which keeps markets efficient

    1. Benjamin Smith  |  September 16, 2021

      Hi William,

      Agree with you on that one. Might be an interesting topic for another article; is it possible for a market to become too passive?

      Cheers,

      Ben

  6. Ramon Vasquez  |  September 15, 2021

    Hello . Just love the Chimp analogy !

  7. Johannes Creemers  |  September 15, 2021

    In my humble opinion you beat the index by buying more on pullbacks. Over 10 years you should see a significant better return

    1. Benjamin Smith  |  September 16, 2021

      Hi Johannes,

      You certainly can do a lot better than an index if you manage to pick the bottom of a pullback- unfortunately, this is a lot easier said than done.

      We’ve written more about the benefits and risks of market timing here: https://www.betashares.com.au/insights/how-market-timing-can-cost-you/.

      Cheers,

      Ben

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