Picking an investment winner – the passive vs active approach
Investors need to examine costs involved as well as investment performance
A perennial issue for investors is whether to opt for a cheaper passive investment or pay a premium for an active investment approach. The former simply “buys the index” - ie, buys shares to reflect their weighting in whichever index or sector they are replicating; the latter attempts to second guess the future direction of the market.
Active funds or passive – what’s the difference?
Active funds try to beat stock market indices; passive funds track the indices.
Passive investing is fine, said UK manager Richard Buxton last week, but it’s “better to buy more of the stocks that will rise, and less of the ones that will fall. . . Man has to be better than the machine”.
Passive proponents, such as finance professor and author Burton Malkiel, say a chimp throwing darts at the Wall Street Journal could select a portfolio as good as the “experts”.
A chimp? Hardly!
It’s true. Last year, like most years, two-thirds of US large-cap funds trailed the S&P 500. Just 10 per cent beat their benchmark in both 2011 and 2012.
Over the past 10 years, finance website NerdWallet found, 24 per cent of 7,630 actively managed products beat the index. The true figures are probably worse – funds that closed down were not included.
No. S&P research shows 66 per cent of global funds underperformed over the past three years. Vanguard found 72 per cent of UK funds underperformed over the last five years, 74 per cent over the last 10 years and 67 per cent over 15 years. For Europe, the figures are 74, 73 and 72 (per cent) for the same periods. Globally, the figures are 74, 64 and 76 per cent, while 82, 87 and 93 per cent of emerging market funds underperformed over those periods.
Don’t active managers offer protection in bear markets, as they have the option of going to cash and taking a defensive posture?
“The belief that bear markets favour active management is a myth,” says S&P. The majority of active funds in eight of nine equity styles were outperformed by indices in the 2008 bear market, and the stats are similar for the 2000-02 bear.
Are fund managers just stupid?
No. You can’t expect most to beat the market – they are the market, and can hardly outperform themselves.
Some will beat the market, some won’t. However, high fees (research, salaries, trading costs) means most must underperform. In the US, the average expense ratio for active funds is 1.3 per cent annually, whereas index funds can be bought for just 0.15 per cent. In Europe, the average charge for an equity exchange-traded fund (ETF) is 0.37 per cent, less than a quarter of the 1.6 per cent charge for the average active equity fund.
“The laws of addition, subtraction, multiplication and division” dictate passive management must win, said Nobel laureate William Sharpe. “Nothing else is required”.