Why (most) investors should be investing actively in 2020
Occasionally we find ourselves drawn into the active vs passive debate. Most recently we commented on an FT guest article written in the context of the LGPS, where the debate is still live.
Let us start by raising our colours to the mast: we are firm believers in active management. That’s not to say that passive investment doesn’t have its place. We are aware of the statistics showing that returns from active managers have generally been behind passive over the past ten years. It is, at least in theory, cheaper- which for us is the only good argument for passive.
The picture is clouded by the growth of smart beta products and the proliferation of indices. They sit somewhere between passive and active. They remain primarily mechanical in their operation, but they are more complex (i.e. more scope for investors not understanding) and more expensive. In fact, fees charged for complex smart beta strategies can actually be higher than large mainstream institutional active mandates.
We have lots of reasons behind our beef with passive. But let’s start with the fact that traditional methodologies don’t take absolute risk into account. Because they are based on market capitalisation weightings, the more a share price goes up, the bigger the index weighting. It has served investors well over the past ten years when momentum has been so strong.
But the result is massive concentration of risk. At the moment, an investment in a passive global equity fund results in 63% in US equities (and the US$), and 13% in just the nine largest stocks (five tech, one bank, two healthcare and one consumer staple – two if you wish to reclassify Amazon). The moment that any of tech., large cap, growth, the US, or the US$ starts to do badly, investors in this strategy are going to suffer relative underperformance. Any half-awake active manager will diversify some of that specific risk away.
Let’s then look at the mechanics of owning an index fund. Our first point is that if you own an Exchange Traded Fund, beware. That’s not because all ETFs will get into trouble, but, depending how they are structured, the bid-offer spread may be substantial, especially if liquidity in the underlying markets dry up – i.e. at times of stress.
Most large passive managers aim to make money from activities such as stock lending and the regular rebalancing in order to offset the cost of running the fund. There is nothing wrong with that, but they all involve extra risk. 99.9% of the time they will harvest the fee, but at time of stress there may be problems and some capital loss.
Our final point is to do with customisation. If an investor wishes to tilt his portfolio away from or even exclude sectors such as fossil fuel, an active manager can usually accommodate that. With a passive mandate it is up to him to choose an appropriate index to follow. Because non-standard indices are more complex, they will almost always be more expensive, substantially negating the no. 1 advantage of passive investing.
We know we have many forces ranged against us. When we commented in the FT, we didn’t get many likes. Some elements in the Government still believes that the LGPS should go completely passive on the grounds of cost. But from the perspective of 37 years investing, we venture to say that they are misguided. If there was ever a time when the balance of probabilities favours active over passive, it is now.