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Passive versus active: It needs no debate
BY JOHN DYALL | THURSDAY, 10 AUG 2017   9:12AM

Have we entered the post-truth world in discussing passive versus active investing?

There has been a lot of talk recently about the rise of passive versus active in equities investing.

It is no surprise the authors on the side of passive investing generally work for index managers (or index providers) while those on the other side work for active managers.

Some of the arguments used are, to be polite, partial to one side or the other. It's a turf war - one which on the evidence of flows the passive managers are winning. Since the financial crisis there has been a nearly $US1 trillion shift from active to passive investing.

The main arguments for passive investment are that, in aggregate, investors cannot outperform the market. This is true to a certain point - in a zero sum game for every winner there is a loser. If there are fees on top it just means the house (the investment managers) wins every time.

And by market it means all the stocks that make up the equities listed on the world's stock exchanges which are also included in investable indexes. It doesn't include private companies which are getting bigger and more numerous.

So for a start there are a whole lot of companies that simply don't want your money (except as a customer). In the US IPOs (Initial Public Offerings) have plummeted. In the 1990s there was an average of 436 IPOs a year in the US. In 2015, there were 120. The total number of US companies traded on US stock exchanges has plunged 45% from the peak of 20 years ago.

So even if you wanted to be a passive investor, the world doesn't work that way. Passive won't get you exposure to a whole world of profit-seeking enterprises. They simply aren't in any investable index.

The other argument for passive is that active managers just can't beat the index, particularly after fees are taken into account. This falls down on two fronts.

Firstly the arguments generally use studies of active managers (or mutual funds since most of the studies come from the US) and then ascribe the percentage over any given time period that these active managers outperformed or not.

There are two problems with this. Firstly, no account (that I've seen) takes into account the size of these funds. A mutual fund with $10 billion has the same weight as one with $50 million. That doesn't really align with the whole market cap-weighted ethos. Secondly, these are so-called active funds.

They might have started out as truly active managers but somewhere along the line profit-seeking entrepreneurs with skill, insight and some luck become rent-seekers where not losing becomes more important than winning.

The arguments from the active side of the fence aren't much better. Some claim that indexing is distorting the markets. The weight of funds flow into index strategies lifts all boats, no matter how leaky. And by lifting the leaky boats, it makes it harder for active managers to beat the market.

True, but were passive managers responsible for the dot.com bubble of 1997 to 2001? Were they responsible for Japan's economy in the 1980s when its stock market tripled and accounted for more than a third of the world's stock market capitalisation?

The fact is that both passive and active managers (and smart beta managers) all create portfolios based on rules. Each of these rules is actively chosen. In the case of active managers the rules are the expression of the investment philosophy of the manager. Passive managers simply have a different investment philosophy, one that is much cheaper to implement.

The goal for the investor is to actively seek an investment philosophy that makes sense to them at a price they are willing to pay. The more investors do this, the more they will be rewarded with products suited to their specific investment needs at the time they need them.

2 comments so far
  

Passive investment is perfect for advisers that don't know what they are doing. Our in-house blend of active managers has consistently performed better than the equivalent passive counterparts & for less risk on the same asset allocation.

Employed passive Business Develop Managers struggle to understand this because all of their research compares to the "average" active manager. Well there's enough rubbish investment funds out there that pull the average down. A fairly simple comparison is merely looking at the average returns for well rated funds. The moral of the story is don't be slack in your fund selection. Ensure you are with a well rated fund & for the public ensure you are with an adviser that can explain the differences in funds to you.

MICHAEL C  |  14 AUG 2017   9.52AM
  

John, well balanced of both side's arguments and representations. My main beef with comparisons of the two is that it assumes one can (and does) invest in an entire universe of active managers. This seems absurd to me as we cannot do so. Its result is meaningless for investors making an informed appraisal.

It also infers advisers and researchers have no means of value-adding in sorting out the entire universe...which seems an unlikely assumption (though not proven) as well.

Second it should remove active managers that are 'index huggers' at an active price. Say an R2 score over 80 longer term?

Third, yes weightings should be applied if doing like for like, but even then the flaw of point one renders it all useless anyway.

Its interesting to view the performance of active managers that gain the bulk of inflows only against the index over 3 and 5 year rolling periods - of say international Australian domiciled funds since 2000.

GRANT PEARSON  |  15 AUG 2017   10.22AM
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