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December 2010
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A Lost Art
Is active management
doomed?
A Lost Art – Is active management doomed?
Contents
2.
Introduction
3.
How big is the shift into passive?
4.
Passive investing in the fixed income sector
5.
Opportunities for active investors
How passive is passive?
7.
Commodity trackers generate losses despite booming prices
Not all active funds are alike
8.
More active = more outperformance
9.
Flaws in the efficient-market hypothesis
Are some markets better suited to passive management?
Market cycles and other factors
10. Are trackers really less risky than active funds?
ETFs can complement active management
12. Conclusion
13. APPENDIX: The Pros and Cons of Passive Management
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A Lost Art – Is active management doomed?
Introduction
The poor performance of many actively managed funds during the 2008 global financial crisis
has reopened the long-running debate concerning the merits of active versus passive funds. By
moving their investments into passive funds, a number of institutional investors indeed appear
to have concluded that actively managed funds offer poor value.
In March 2010, investment consultant Towers Watson said that the number of searches it had
carried out worldwide for index-tracking managers had increased fourfold over the past two years.
It added that it expected passive investing to account for around half of assets under management
within the next 10 years, up from a quarter to a third of institutional investor assets in 2010.
A number of large pension funds have already taken action. For example, the £10.5bn scheme
sponsored by Royal Dutch Shell in the UK announced in March 2010 that it had placed an upper
limit of 40% on the amount of its equity portfolio that it would entrust to stock pickers. It had also
increased the proportion of its fixed income investment allocated to passive managers.
Shell wrote: “Active management, where managers pick stocks or bonds rather than just follow
the index, has not been very successful for many investors during this period of market turmoil,
and the trustees have decided that they want to track the market indices more closely.”
A Lost Art – Is active management doomed?
How big is the shift into passive?
Yet despite some high profile actions, there is limited evidence of a wholesale move away from
active management. Moreover, as this paper seeks to show, there are good reasons to believe
that active management has been unfairly maligned, and that those institutions that have decided
to shift assets away from active managers may be missing an opportunity.
According to the Investment Management Association’s (IMA) annual survey entitled ‘Asset
Management in the UK 2009-10’ (published in July 2010), in the institutional arena there is a
“clear year-on-year change in assets managed passively, with an increase to 24 per cent of total
institutional assets under management in the UK by the end of 2009” – a four percentage point
increase on a year previously.
However, the IMA added that it was not clear whether the increase was primarily the result of
relative asset price movements or “actual client decisions to move from active into passive”.
Many active funds performed relatively poorly during the financial crisis, and this has undoubtedly
fuelled a reappraisal of the value of active investing. However, on a more immediate level the
poor showing from active funds adversely affected the assets under management in active
mandates more than passive ones. The IMA’s comments highlight the difficulty in separating
these two factors when assessing fund flows.
The IMA added that, as in previous years, the deployment of passive management was most
widespread in the pension sector, which covers both the corporate and local authority categories.
It explained that at the end of 2009, passive mandates accounted for 35 per cent of pension
fund assets managed in the UK on behalf of domestic and international clients. It also pointed
out that the use of passive mandates in the pension sector contrasted sharply with other areas
of the institutional market, particularly the insurance sector, which is primarily actively managed.
Times of stress inevitably bring talent into sharp focus. The financial crisis certainly underlined
the difficulties faced by active managers, coupled in some cases by shortcomings in risk control.
Coming as it did at the same time as significant regulatory developments in the form of UCITS
III, the crisis heightened investors’ awareness of the risks of active investing.
However, we believe that active investing has a real role to play in the future. Indeed, as we shall
explain, we believe that the current growth in passive approaches, and the expansion in the tools
available to managers, provides exciting opportunities for active investors. In selecting active
managers, we concur with the IMA in the belief that, “specialist alpha, based on a proven ability
to outperform significantly and more innovative use of that alpha, are likely to remain key features”.
Importantly, active managers are well-placed to meet the growing investor need for products with
the following characteristics:
 Unconstrained portfolios that can combine superior performance with limited correlation with
underlying markets.
 Absolute return products targeting positive returns throughout the investment cycle.
 The alpha component of “portable alpha” approaches that seek to combine an investment
gain derived from fund manager skill with a return that has been suitably matched to
underlying liabilities.
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A Lost Art – Is active management doomed?
Passive investing in the fixed income sector
If it is hard for active managers to add value in the equity sector (though many do), it can be even
more difficult for them to do so in government bonds, and thus the case for passive managers
is stronger here. For example, in the case of US Treasury debt, all bonds of the same maturity
will provide virtually the same return and, as a result, there is minimal scope to add value via
security selection unless the manager has significant investment freedom within and outside
the benchmark index.
Investment strategy between markets has historically been a source of alpha. For example, recent
sovereign risk concerns have brought a divergence in the performance of investment grade
government issuers, with peripheral European government bonds sharply underperforming their
core counterparts.
Duration management and yield curve positioning also offer some potential to add value versus
an index, but it is notoriously difficult to predict the direction of interest rates and changes in the
shape of the yield curve. Moreover, the quantum of likely outperformance is modest for even the
most successful active manager in government bonds.
Despite the potential difficulty in adding value from active management, government bonds remain
popular with institutional investors because they provide a highly dependable stream of cash flows
that can be used to match known liabilities. This match, combined with the apparently limited
potential sources of alpha, has seen passive government bond portfolios gain in popularity in the
institutional market, almost irrespective of the price that is paid.
The longevity of this trend is a matter of some debate. For the past 20 years, buy-and-hold bond
investors have benefited from consistently falling interest rates. However, interest rates are now
at all-time lows in many markets that are unlikely to be maintained in the longer term. As rates
eventually normalise, the ability to adjust the portfolio to take advantage of opportunities and avoid
pitfalls is likely to be much more important. Duration and curve management may become
increasingly powerful tools in this environment.
Further down the credit curve the case for active management is already relatively strong. For
example, sub-investment grade corporate bond performance is much more a function of issuer
fundamentals – more akin to equity investing – than treasury market technicals. Performance
divergence between issuers is high and bottom-up analysis of the credit outlook for issuing
companies, therefore, affords the scope to add significant value. Similarly, in emerging market
bonds, understanding political factors and appreciating the inefficient nature of markets gives
active managers a greater chance to add value.
The appeal of active management in lower grade fixed income markets is further enhanced by
the tendency of traditional indices to become dominated by the most indebted issuers.
Companies or governments that are paying down debt tend to outperform but, as they do so,
their size in the index diminishes. Conversely, issuers that are on the road to default will often
be avoided by talented active managers. Passive funds will tend to be structurally overweight in
issuers with large volumes of debt outstanding and underweight in companies with a positive
credit outlook. For these reasons, active management appears well entrenched in credit markets.
A Lost Art – Is active management doomed?
Opportunities for active investors
The perceived shift from active to passive has been a popular topic of press comment in recent
years. For example, in June 2010, ‘The Financial Times’ cited a report by Citigroup, Principal Global
Investors and Create Research forecasting that the investment industry was set for a “massive
rebalancing” from active to passive fund management, “as disillusionment about the ability of
active managers to beat benchmark indices persists”.
The report stated that the scale of the financial crisis in 2008 was likely to lead to a “flight to
quality, simplicity and safety: quality defined by consistent risk-adjusted returns; simplicity by
transparency and liquidity of the strategies being used; and safety by capital protection”. The
report added that “clients know that safe liquid assets mean low returns”.
Consequently, the authors predicted a wholesale move into passive funds, which are viewed as
transparent, liquid and safe. It forecast that the proportion of global assets being managed
passively would rise from 15 per cent to 25 per cent over the next 10 years, led by a rebalancing by
sovereign wealth funds, Australian pension funds’ new-found desire for equity derivatives, and
a sharp reversal by US retail investors, who have withdrawn US$350bn (£218bn, €250bn) from
actively managed funds and pumped US$500bn into passives in the past two years. It added that
“pension fund consultants reckon that something like 50 per cent of new pension money coming
into the market will go into passives by the end of the decade”.
If this forecast proves to be accurate, we believe that the wall of money falling into passive funds
will create significant opportunities for active managers. This belief was echoed in the report:
“Price anomalies will be rife as market cap weightings carry concentration and momentum risks.
The market will become inefficient and open alpha [index beating] opportunities for active managers
will increase.” The authors indeed added: “If this flow materialises, then within three to five
years, the process will begin to reverse because there will be too many opportunities outside
the indices. Far from active management suffering an ice age, soon people will get out of passive
and into active again.”
Other reports also suggest that the proportion of funds flowing into active funds will increase over
the next few years. In May 2010, a survey of 152 pension professionals, conducted by Clear Path
Analysis, found that over half the European defined-contribution (DC) corporate pension schemes
that invest their default funds in a purely passive manner intended to embrace active management
within the next 12 months.
The respondents, who included trustees, pension fund managers and chief executives, cited the
possibility of outperformance and wider choice as the top reasons for adopting active management.
Interestingly, many DC schemes, while keen to reduce risk, believe that the best way of doing
so is by diversifying into asset classes such as hedge funds, private equity, infrastructure and
property, which can be difficult to access in a passive manner. In other words, these respondents
may believe that a range of active strategies will produce a more diverse, and hence less risky,
range of returns than simply pursuing a passive route.
How passive is passive?
In October 2010, UK financial services provider Hargreaves Lansdown published a report that
confirmed what many people have long suspected: trackers underperform over the long term.
The reason for this underperformance is simple: passive funds measure their performance against
their benchmark index before the impact of charges is taken into account. Once management
fees and dealing costs are incorporated, passive funds will struggle to keep up with a given index.
Some managers engage in practices such as stock lending or deal timing in a bid to offset the
drag from fees. However, these practices introduce elements of risk that passive investors might
not expect.
The way that funds choose to mirror the index will also affect performance. Trackers can either
fully replicate the index or use a sampling technique. Trackers that fully replicate the index buy
and sell when stocks enter and leave indices. This method is arguably the most accurate way of
mirroring an index.
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A Lost Art – Is active management doomed?
But it also means that the funds are buying stocks at the top of the market (as they move up the
index or enter it for the first time), and that they may be selling a holding just when it is at its
weakest (as it drops out of the index or moves down the weightings).
Passive funds that use a sample replicate only the big stocks in each sector and take a sample
of the remainder, holding a little more of one and a little less of another. However, the actual
weighting of each sector in the tracker fund will be the same as its index weighting.
The sampling approach also carries risk, primarily in that a fund using this method will have a
greater deviance from the index than a fund that simply replicates the benchmark. As the
portfolio is not a direct representation of the actual holdings and weights in an index, returns
will be skewed away from its returns, and the tracking error can be wider than investors might
otherwise expect.
Inevitably, the two methods (sampling and fully replicating the index) lead to variations in
performance, starkly highlighted by an incident involving Dimension Data in 2000. On 15th
September 2000, IT company Dimension Data entered both the FTSE100 index and the All-Share
index. Its price rose sharply, from £6.70 to £10, within minutes. But the shares plunged to £6.88
on the following trading day. Trackers that had bought the stock at £10 suffered a dip in
performance, while those trackers that bought the shares at the lower price benefited. Many
index trackers were compelled to buy the stock at the highest price.
Hargreaves Lansdown found that, on average between 1990 and 2010, tracker funds had
underperformed the UK All Companies sector by 0.46 per cent per annum. Clearly, the larger
the management charge, the bigger this difference will be – and it will increase over time, so
that a substantial shortfall will be recorded over a five or 10-year period.
The results were based on an analysis of how tracker funds had performed over the last 20 years.
The company compared tracker fund performance to the UK All Companies sector (which includes
passive and active funds), using all the funds in each sector. The graph below provides a snapshot
of the results.
Performance of tracker funds compared to the UK All Companies sector
(including all passive and active funds) 1990-2010
500%
400%
300%
200%
100%
0%
IMA Passive
Jun-09
Mar-10
Sep-08
Dec-07
Jun-06
Mar-07
Sep-05
Dec-04
Jun-03
Mar-04
Sep-02
Dec-01
Jun-00
Mar-01
Sep-99
Dec-98
Jun-97
Mar-98
Sep-96
Dec-95
Jun-94
Mar-95
Sep-93
Mar-92
Dec-92
Jun-91
-100%
Sep-90
6
IMA UK All Companies
Source: Hargreaves Lansdown
Tracker funds also underperform the FTSE All Share, according to Hargreaves Lansdown,
“by an annual average of 0.96 per cent per annum – more than the annual management fees
of most trackers”.
In other words, Hargreaves Lansdown says, “it doesn’t matter what the level of fee, trackers
underperform”.
A Lost Art – Is active management doomed?
The performance of trackers versus the FTSE All Share, 1990-2010
600%
500%
400%
300%
200%
100%
0%
IMA Passive
Jun-09
Mar-10
Sep-08
Dec-07
Jun-06
Mar-07
Dec-04
Sep-05
Jun-03
Mar-04
Sep-02
Dec-01
Jun-00
Mar-01
Sep-99
Dec-98
Jun-97
Mar-98
Sep-96
Dec-95
Jun-94
Mar-95
Sep-93
Dec-92
Jun-91
Mar-92
Sep-90
-100%
FTSE All Share TR
Source: Hargreaves Lansdown
Commodity trackers generate losses despite booming prices
The level of underperformance in other asset classes can be even greater than in equities. In
October 2009, for example, Reuters reported that many commodity tracker funds had significantly
underperformed. The news agency said that while the Goldman Sachs Commodities Index had
risen by nearly 45 per cent over the previous year, the total return received by investors amounted
to just 12 per cent. “Measured since January 2005, the picture is even worse”, the agency added,
for despite a boom, which had driven up the index by about 60 per cent, investors had actually
lost about 15 per cent of their capital over four years.
Reuters explained that while US$100 billion had been invested in commodity tracker funds,
according to Standard & Poor’s estimates, problems were now becoming apparent.
Commodities need space and insurance for storage, so the funds buy the commodities forward,
selling them before having to take physical delivery and buying forward again. Traders have strict
rules concerning how and when they roll the contracts; hence, they “can see the forced sellers
(and buyers) coming a mile off, and move their prices accordingly”.
The agency said that the more a fund grew, the greater the charges that traders could demand
to roll the fund’s contracts. Consequently, these funds were guaranteed to underperform against
the relevant index, and the longer the investment was held, the greater the underperformance
would be.
For further information see our Threadneedle Viewpoint: The Case for Active Investment in
Commodities, October 2010.
Not all active funds are alike
The distinction between active and passive investing is not as clear as might be assumed.
Some passive funds, as we have seen, engage in practices that could be described as active in
order to counter the drag on performance from management charges. At the same time, active
investing covers a wide range of approaches from funds that take only minor positions against
an index to completely unconstrained, high alpha portfolios. Many of the studies that compare
actively managed funds with passive strategies fail to acknowledge this range of approaches.
Academic studies suggest that, like passive funds, so-called “closet index trackers” also
underperform once charges are taken into account. In 2006, for example, Antti Petajisto and
Martijn Cremers of the Yale School of Management found that closet indexers had merely
matched their benchmark index returns before expenses, yet once expenses were taken into
account, they had lost to the benchmarks by about 1.4 per cent per year. By contrast, the most
active funds had outperformed their benchmarks by about 2.7 per cent before expenses, and by
1.4 per cent after expenses.
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Hence, investors who conclude that active funds have a limited appeal – given that the sector
in general has underperformed over a certain time period – may be acting on the basis of
inadequate information.
Many investors may also fail to screen active managers adequately. A number of studies have
found that institutional investors are paying for active management, yet the managers are
simply investing in funds that differ little from the index. This may be because institutional
investors, particularly pension funds, tend to be more risk averse than other investors and are
content to invest in funds that will rarely stray from the index. There are, of course, legitimate
reasons for funds to be correlated to a benchmark over the short term; however, longer-term
correlation could indicate that funds are not being actively managed to a significant degree,
and certainly not enough to justify the management fee.
More active = more outperformance
Petajisto and Cremers’ 2006 study produced intellectual evidence to support the claim that active
managers can consistently outperform. They also highlighted the extent to which index funds
were masquerading as active managers.
The academics came up with the idea of the Active Share. They said that whenever the portfolio
weight on an individual stock exceeded the stock’s index weight, the fund was taking an active
long position in the stock; similarly, a position less than the index weight implied an active short
position in the stock. The sum of the active positions then indicated how active the fund was.
The researchers studied 2,650 funds from 1980 to 2003, and found that the most active funds
tended to create value, while closet trackers destroyed value.
The research differentiated between two types of funds with high active share:
 Those run by traditional stock pickers, whose focus is on taking concentrated positions
in a relatively small number of stocks, and who make decisions on the merits of each
individual stock.
 Fund managers who make “factor bets” – rotating into and out of sectors on the basis of
macro-economic judgements.
The research showed that, as a general rule, funds focused on stock selection generated better
returns than those that made market timing calls, although as long as they were truly active,
both tended to outperform their index after expenses.
Moreover, the research suggested that the view that active funds in general underperform is
skewed by the performance of the very large funds that dominate the industry. Thus, the
authors found that in 2003, only half of self-described active funds were truly active, with an
active share of 80 per cent or higher, compared to eight out of ten funds with a similar active
share in 1980.
They also found that larger funds tended to have lower active share, and that smaller actively
managed funds outperformed large actively managed funds by about 2 per cent per annum.
Finally, they asserted that there is a direct correlation between true active management and
performance. Funds with the highest active share outperformed their index after expenses by
1.5 per cent, while the least active funds underperformed by 1.5 per cent – so, on this evidence,
there is a gap between high active and low active share funds of almost 3 per cent each year.
The evidence from the UK also suggests that choosing the right active fund manager can
significantly affect returns. For example, the top 10 active funds in the IMA UK All Companies
sector significantly outperformed the FTSE All-Share Index over the 10 years ending November
2010, returning 128 per cent on average, compared with just 36 per cent from the index.
A Lost Art – Is active management doomed?
Active and passive returns, FTSE All Share Index 2000-2010
250
200
150
100
50
FTSE AllSh TR GBP
Top 10 Actively Managed Funds (as over 10 years)
Jul-10
Nov-10
Mar-10
Jul-09
Nov-09
Mar-09
Jul-08
Nov-08
Mar-08
Jul-07
Nov-07
Mar-07
Jul-06
Nov-06
Mar-06
Jul-05
Nov-05
Mar-05
Jul-04
Nov-04
Mar-04
Jul-03
Nov-03
Mar-03
Jul-02
Nov-02
Mar-02
Jul-01
Nov-01
Mar-01
Nov-00
0
Passive Funds
Source: IMA, Morningstar
Flaws in the efficient-market hypothesis
Are these findings really so surprising? If the efficient-market hypothesis – the intellectual basis
underpinning index tracking – were correct, then the argument in favour of passive funds would
be very strong. But the market is clearly inefficient and can misprice companies. As Warren Buffet
has pointed out, if markets are efficient, why does he do so well by picking individual stocks? It
is certainly the case that a good fund manager, supported by all the research and analytical tools
deployed by an investment business, can exploit those inefficiencies.
Meanwhile, passive investors are forced to hold the few large stocks and sectors that dominate
market indices. This can sometimes lead to the heaviest losses, such as those generated by the
banks, which weighed heavily on the FTSE 100 Index during 2008. This concentration in certain
stocks and sectors can be extremely risky. Furthermore, when the index rebalances, trackers
are forced to sell departing stocks at their cheapest and buy those that are entering at their
most expensive.
Are some markets better suited to passive management?
It has been argued that passive funds are better suited to reputedly efficient markets such as the
US, where there is a wealth of information about companies and the economy in general, and
where analyst coverage of stocks is relatively broad. With such a wealth of information, the
argument runs that active managers will find it hard to add value.
Conversely, emerging markets are arguably much less efficient than their US counterparts because
of the relative lack of intelligence on all but the biggest businesses. But is this really true? The
evidence would suggest otherwise. Price anomalies occur regularly in both developed and
developing markets, which explains why talented active managers consistently outperform in
the US and other developed markets. Indeed, our experience of managing US equities tells us
that analyst coverage is surprisingly shallow, and that it becomes increasingly so lower down
the capitalisation scale. Real value can and has been added by stock picking based on in-depth,
fundamental analysis of companies.
Market cycles and other factors
Active funds underperformed in the most recent market crisis and, indeed, research has shown
that the efficacy of active versus passive investing varies through the investment cycle.
For example, a 2010 study by FundQuest, which advises fund managers, found that active
management delivers superior risk-adjusted returns in bull markets but underperforms in bear
markets. The study evaluated the performance of 31,991 US-based mutual funds over five market
cycles from January 1980 until February 2010. It found that, in aggregate, active managers
outperformed by 0.66 per cent per annum in bull markets but underperformed by 0.68 per cent
in bear markets.
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A Lost Art – Is active management doomed?
These aggregate figures mask a marked divergence at the asset class level. Active equity portfolios
were found to add significant value on a risk-adjusted basis in bull markets but generated negative
alpha in bear markets. Conversely, active fixed income managers were more successful in bear
market conditions. However, within fixed income, emerging market bonds stood out as generating
positive alpha in both bull and bear markets. This perhaps illustrates the specialist nature and the
relative inefficiency of the asset class.
The study also examined other factors that might affect an active fund’s ability to outperform.
Among these, it was found that positive alpha was more likely in funds where:
 Fund manager tenure was relatively long.
 Total expense ratios were low.
 Volatility was low.
 The manager had outperformed in the previous cycle.
These findings support our contention that a stable investment team is an important ingredient
of long-term outperformance.
Are trackers really less risky than active funds?
Many institutions use tracker funds in the belief that they reduce and contain risk. But is this
really true? The theory is that since active managers look for over- or under-priced assets and
then alter their portfolios to exploit such situations, the potential risk increases, for the manager
may buy heavily into or out of one stock or sector. As more and more mispriced assets are taken
on, the risk increases, leading to larger gains or losses and greater levels of volatility than are
experienced by the index.
However, passive funds are clearly biased towards the index, which can itself be heavily weighted
to just a few large companies or sectors. This can cause passive funds to be more concentrated
than their investors might like. By contrast, an active manager can avoid benchmark stocks that
appear overvalued or have poor management or are in a sector that is inherently weak.
Another way to consider this difference is to think in terms of beta (the element of performance
derived by moves in the market) and alpha (performance resulting from fund manager skill).
Passive funds’ performance is almost completely beta-driven, and this introduces risks for
investors benchmarking against fixed liabilities or cash.
Active funds obviously also take risk, but here it is deliberate and considered risk in pursuit of alpha.
Competing active managers derive their alpha from different sources, which leads to limited
correlation between active portfolios. As such, combining carefully chosen active managers can
be a good way of lowering a pension fund’s reliance on beta and is likely to lead to better riskadjusted returns, as borne out by the FundQuest research discussed above.
ETFs can complement active management
Exchange Traded Funds (ETFs) are investment funds that hold a range of underlying assets and
whose value closely approximates that of the underlying assets. As their name suggests, these
funds are traded on stock exchanges. They frequently mirror an index, making them an alternative
to traditional passive portfolios. ETFs have gained significant market share in recent years and
have also become increasingly sophisticated. Clearly, passive ETFs provide a vehicle for investors
wishing to match the return of a market index. However, ETFs have also been developed that
seek to run their money actively and to beat indices.
This new generation of funds aims to outperform by underweighting or overweighting particular
index holdings. Yet they continue to offer lower costs than actively managed funds. However,
rather than regarding ETFs as a threat, an increasing number of active managers are using these
funds to enhance their own performance. ETFs, for example, give active managers the means
to achieve quick and cheap exposure to an asset class in order to implement a particular view
over a short time frame. Indeed, it could be argued that both tracker funds and ETFs are tools
A Lost Art – Is active management doomed?
for active managers to generate outperformance through the deployment of superior assetallocation skills.
The ways in which ETFs are being used by active managers illustrate the latter proposition.
In terms of equities, ETFs can be deployed by managers with a global mandate to provide alpha
generation. They allow a manager to adopt an overweight in a particular country, region or sector.
The bull run from 2003 to 2008 certainly provides examples of certain markets and sectors
performing more strongly than global benchmarks. The same is true of the bear market that lasted
until March 2009 and the subsequent return of the bulls.
ETFs can also be used to pursue specific investment strategies, such as adopting a long or short
position in currencies. Currency ETFs bring diversification benefits, and they can also prove highly
profitable, as was highlighted (in the case of currency ETFs) during the sovereign-debt crisis in 2010.
In summary, as a standalone product, ETFs offer many of the advantages and disadvantages of
passive funds – cheapness, transparency counterbalanced by widely varying fees (which in some
cases can be substantial), and concerns over potentially large tracking errors.
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Conclusion
The recent global financial crisis has refuelled the active versus passive discussion, with proponents
from both sides drawing their own self-supporting conclusions. The advocates of passive investing
point to the underperformance of active managers during 2008 as evidence that their beliefs are
correct. But the recent stresses and gyrations in asset prices suggest that the efficient-market
view of the world, the intellectual foundation of passive investing, might also require revisiting.
The truth, as ever, is more complicated than either side would like to admit. While passive funds
might offer the advantages of transparency and cheapness, they can and do underperform the
market, they clearly will never outperform significantly and their advantages in terms of risk
have sometimes been overstated. Likewise, many active managers underperform or closely
track the benchmark despite levying high charges. However, a number of funds consistently
outperform the benchmark and there is also evidence that combining well-managed active
portfolios can produce impressive risk-adjusted returns with less reliance on market beta.
Moreover, active fund management is part of the process by which resources are allocated
efficiently in the free market. If all investors adopted the passive approach, there would be no
means of differentiating between companies. Only active fund managers have the freedom to
say no to a badly managed company that is seeking to raise money for a poorly thought-out
acquisition. Conversely, they will discriminate in favour of a soundly managed business with a
rational expansion plan. It can certainly be argued that trackers simply exploit the work carried
out by active managers in this respect while making no contribution of their own.
Investors will doubtless still be arguing over the merits of passive and active investing in 20
years’ time. We believe that the two styles can complement each other, with active managers
using ETFs and other tracking tools to enhance their performance and/or reduce risk to the
benefit of all investors.
A Lost Art – Is active management doomed?
APPENDIX: The Pros and Cons of Passive Management
Advantages
The cheapness of index funds is clearly their main advantage over active funds. Since they simply
replicate the index, there is little intellectual input and thus management fees are relatively low.
Risk of significant underperformance is limited. Thus, the funds appear ideally suited to cautious
investors.
Trackers are also ideal for investors that may not be able to carry out due diligence to ascertain
which active managers best suit their needs.
Passive government bond portfolios can be an efficient way for pension funds to match assets
and liabilities.
Disadvantages
It can be difficult to discriminate between trackers. Since they are required to mimic their
benchmark indices, there is no simple way to tell whether one index fund is better than another.
One of the very few ways to compare index funds is tracking error, which surprisingly can vary
widely between different passive funds. However, tracking errors are backwards looking and
complex and can be calculated in different ways, making comparisons difficult. Indeed, so many
variables are used that a fund could be closer to replicating the index than one of its peers and
yet still have a higher tracking error.
Equally, tracking error alone cannot identify closet index trackers. In 2006, Antti Petajisto and
Martijn Cremers of the Yale School of Management announced another means of doing so –
the Active Share discussed earlier in this report.
They found that the active share of “active” all-equity mutual funds in the US ranged from 30
per cent to 100 per cent, with an average of 66 per cent for large-cap funds. Thus, the average
large-cap fund essentially indexed one third of its assets, while the worst closet indexers indexed
two thirds of their assets. The authors also concluded that closet indexing has become much
more prevalent over time – in the 1980s, virtually all funds were reasonably active.
Interestingly, they found that the tracking error of a fund has no predictive power for future
returns – if anything, high tracking error is related to lower future performance. Even though
both tracking error and active share measure active management, they capture somewhat
different aspects of it: tracking error emphasises the systematic risk a fund may take relative to
the index, while active share emphasises individual stock selection.
Passive funds tend to buy at the top of the market. All indices are rebased regularly, with stocks
moving up to take greater weightings, entering the index for the first time or dropping out
completely. As a stock moves up the index, a tracker will take a greater stake. However, this tends
to happen after a company has performed well, which means that the tracking fund is buying as
the share price increases, and such hikes can be exacerbated by market trends or investing fads.
The dotcom boom of 1999 provides a perfect example of the dangers of passive funds. The fever
for technology stocks led to an increased representation of technology stocks in many indices.
However, indices rebalanced towards tech stocks just as the market hit its peak in March 2000.
Consequently, while passive investors would not have gained as these shares shot up in value
(as they were not in the index), they were fully exposed to the technology sector just when the
bubble burst. Indeed, this exemplifies one of the key criticisms of index funds: they replicate past
performance rather than looking at the future.
13
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