The wider debate around active vs. passive investing
From a broad perspective, passive investors have generally beaten active investors over the past ten years. But this is on the basis of collective investment funds, not discretionary management. And there are still significant numbers of active funds which have beaten the market over the past ten years. The challenge has been to identify these funds, which is what our Fund Research team does.
The advantages that individual investors enjoy can tilt the odds of succeeding with active management in their favour. Perhaps most important is the ability to take a long-term approach. Academic studies have found that patient stock-pickers, who genuinely take active decisions, have been successful in outperforming the market over the long term. Because we manage money according to your own personal circumstances, we can avoid the short-term pressures that many active managers face, and are able to invest for the long term.
Active managers perform better in certain markets
There are reasons – both cyclical and structural – to believe that active managers will perform better than passive funds going forward. On a cyclical, shorter term basis, market conditions are gradually becoming more favourable for active managers. Higher market volatility creates opportunities to add to favoured stocks.
We are also seeing greater stock dispersion – i.e. a widening difference between poor performing companies and strong companies – meaning that active managers are better rewarded for choosing the right stocks and avoiding the wrong ones.
The type of companies which have led markets up over the past decade may also be changing. We’ve seen big multi-nationals – like Facebook, Amazon, Apple and Alphabet – lead stock markets higher in recent years. Now that these companies have achieved sufficient scale, they have become hugely cash generative, with plenty of surplus capital to plough back into new technology. But much of this has now been factored into stock prices, and as investors look to other companies, those active managers who have already looked elsewhere for returns should benefit.
In a world where interest rates have remained low for an extended period, a lot of companies have arguably survived when perhaps they may naturally have been put out of business in more ‘normal’ environments. Whilst this may sound negative, this is simply the efficient market in action. Without this, poor companies that active managers may have avoided continue to exist. As conditions normalise, we are likely to see more bankruptcies in companies which the index is forced to hold, but that active managers can avoid.
From a structural perspective, we believe the wider active universe is attractive for three core reasons:
- Market returns are likely to be lower in the short term than they have been over the past decade. The extra return you can gain from active managers is thus more important.
- The rise of passive investing has put pressure on active managers to reduce fees and improve performance. The universe of higher quality active managers has therefore increased relative to poor quality active managers.
- Our large fund research team can identify the best active managers, those capable of generating long-term outperformance.
The caveats of the active-passive debate
Furthermore, there are certain asset classes where the evidence is already in favour of active management. This is generally the case when investing in fixed income and other debt instruments. According to a study by US bond manager PIMCO, more than half of active bond mutual funds and ETFs beat their median passive peers in most categories over one, three, five, seven and ten years to the end of December 2016.
Why do active fixed income investors have a better chance of outperforming than active equity investors? PIMCO, a US asset manager, proposed several arguments in a 2017 paper, including:
- non-economic investors are more important in fixed income asset classes (a non-economic investor is someone like a central bank or insurance company, who might invest for reasons other than just short-term returns)
- the regular rebalancing passive fixed income investors need to undertake
- the fact that many active fixed income investors invest outside of the regular benchmark
This is not to say that passive fixed income exposure is inappropriate – a passive fixed income vehicle can be very useful for tactical considerations and as to help diversify a portfolio. But investors should be prepared to look beyond the headlines of the active/passive debate and this can even apply to the most basic of assumptions, that active exposure is expensive, and passive vehicles cheap.
Addressing the issue of cost
Generally speaking, passive funds represent a cheaper way to invest. But this is not always the case however. The iShares MSCI Emerging Markets ETF, for example, has an expense ratio of 0.69% and several actively managed emerging market funds come close to matching this cost. Arguably, the smaller the difference in costs between an active and a passive fund, the more sense it makes to invest actively. With a passive fund, you are locking in underperformance of the market (you match the market return, but then have to pay for the cost of investing).
In some cases, an actively managed strategy may even be better. While your portfolio will be managed on a discretionary basis at Quilter Cheviot, we can use the total volume of assets we manage to negotiate better terms for our clients. This means, for example, that the cost of several of our actively recommended Japanese equity funds is lower than the cost of several passive options. While the lowest cost passive should always be cheaper than the lowest cost active fund, investors should always keep an eye on costs, rather than simply assume that passive equals cheap.
Conclusion
The past ten years have seen a significant evolution in the active-passive debate. The growth of passive investing has upended the active managers, forcing many to bear down on costs and bringing a laser like focus on performance. We welcome this change, and believe there are compelling opportunities for active investors in future. From our perspective at Quilter Cheviot, we have two main areas of focus when it comes to the active-passive debate:
- How can we effectively pick companies which will outperform the market?
- How can we choose external active managers who can outperform the market?
To help deliver in these two areas, we have built up an extensive and well-resourced research team, one of the largest in the discretionary management space. Our research team acts as a resource for all of our investment managers to use, and we hold regular meetings and updates to make sure investment managers understand the investments we cover. By doing this, your portfolio can contain what we believe to be the best opportunities from around the world, ones tailored to your specific financial circumstances, and maximising the chances of meeting your investment objectives.
