The long running debate over active vs. passive management shows no sign of abating, abating with the ‘pro-actives’ convinced that their brand of investment management is superior to the ‘pro-passives’, because of the potential to outperform any given index and claims of the downside protection it offers as well. The ‘pro-passives’ in turn point to the lower costs and relative returns of their brand to counter the argument, with a regular claim of “passives outperform actives”.
Looking at the performance debate, the following charts compare the performance of an index, a passive fund and one of MitonOptimal’s preferred active funds in the largest, deepest and most liquid equities market in the world – the US – over different time periods.
Fig 1: Since March 2000
Fig 2: Since January 1, 2008
Fig 3: Rolling 5 Years to 17/7/2017
On the face of it, the case that passives perform better than actives is not made, particularly when looking at the massive outperformance of the active manager over both the longest time frame and since 1st January 2008, which captures the market crash later that year. It is, however, less clear cut when one considers the more recent, five-year, performance, with a spread of just 4.51% total over that period between the best and worst performer.
Is it true, therefore, to say that active actually outperforms passive? The answer to that is no, although perhaps a better statement is that some active funds outperform passive funds, and vice versa: a statement that gives some clue as to my eventual conclusion.
However, it is interesting to consider the cause and effect of the growth of passives over the past decade. In the US, for example, 37% of the entire equity market is now owned by passive investors and the Vanguard 500 Index Fund featured in the above charts actually owns 6.8% of the entire market capitalisation of the S&P 500 and greater than 5% of the market capitalisation of the 491 stocks in the index. [Source: FT.com 17/7/17]
The question therefore… is now no longer about active vs. passive, but what is the optimal combination of both, in an actively managed portfolio?
Whilst not the one set out in our title, one question that this poses is whether or not the rise of passive investment is actually distorting the market. If US$370 of every US$1,000 invested replicates the weight of each stock in the index, it follows that more funds are invested in larger companies than in smaller capitalised stocks, leaving supply and demand to distort the price at each end of the spectrum accordingly.
This leads to the index itself being reshaped, which in turn reshapes the passive investment vehicles, which the feeds straight back into the distortion. This may help to explain, in part at least, the convergence of returns over the past five years in the above examples.
Add into this mix, the scenario whereby passive investors are obliged to hold investments such as Snapchat (a company with minimal revenues, massive losses and no cash) or participate in the impending Saudi Aramco flotation even though just 5% of the issued share capital will be available to investors, leaving them a hostage to the whims of the Saudi sovereign holding the other 95%. Also, consider that, if you are a passive investor, you either have to make some active decisions about when to (dis)invest, otherwise, your fortunes will rise and fall with your chosen index.
If you have read this far, you may be forgiven for thinking that we at MitonOptimal are firmly in the pro-active management camp. My answer to that is, as an active manager, we naturally believe in active management, but, in delivering our strategic asset allocation models, we are happy to use both active and passive management solutions. The key to this stance, therefore, is actively adding and removing funds of both brands in a timely and effective way.
Passives represent a quick, easy and cost-effective way for us to represent a given theme in our portfolios, especially in deep and liquid markets and where no obvious specific active manager is providing any outperformance.
At the same time, where a manager clearly demonstrates outperformance on a consistent basis, and that manager passes our due diligence tests, then we would prefer to hold this to a passive instrument. Moreover, when it comes to less deep or liquid markets, we would always look to an active solution and use our efforts and resources to find the best manager to represent that allocation.
The question therefore for MitonOptimal is now no longer about active vs. passive, but what is the optimal combination of both, in an actively managed portfolio?
Active vs. Passive Management - Is this still the right question?
