The Active vs Passive Debate
I saw an interesting article from Warren Buffett recently. He challenged a group of Active Fund Managers to do better than putting money in a passive indexed fund. The challenge was accepted. Buffett invested passively & left the Active Managers to their own devices. Buffett won, with no effort.
It's a very interesting debate… one I’ve heard since I was at University back in the early nineties. To be fair, there are always two sides to every story, but if we had to agree on one, we’d surely back the Oracle of Oklahoma (Mr Buffett). That said, I have some sympathy for the Active Managers and besides, isn’t Berkshire Hathaway (Buffett's company) an "active" investor?
85% of Fund Managers won't beat the market in the long term (we're talking about world markets). What Mr Buffett doesn't explain well, is that investors lose confidence at different times and they lose the most confidence when markets are in trouble. If I recall, the article mostly talks about the "average" and as I said, I agree that 85% of Fund Managers will not beat the market!
It's interesting that the race Mr Buffett had with those Hedged Fund Managers (Hedge Fund Managers are a different breed anyway), came to an end when share markets just happened to be at all-time highs. In that regard, Mr Buffett had very good timing (he made the bet when things were starting to recover). He’s been around long enough to know it was likely a “safe bet” and, he was taunting a group of managers that tend to have a rather high opinion of their own ability.
Here's what Mr Buffett doesn't say; market results are not linear and investors may spend a lot of time feeling lost and distressed by these results when it’s not going that well. So, when the heat is on, many investors will exit and realise a loss. They may hope to come back in when things have recovered but, we all know that’s a fool’s errand. Active Managers can insulate this to a degree and they certainly do make it easy to invest (not everyone is an experienced investor).
Investing takes patience & fortitude, which comes with time and knowledge. Very often, investors sell or buy at the wrong times. Only hindsight proves when the best time actually was (this is true even for Fund Managers, who are the “supposed” experts). I said to someone recently: How can anyone have lost money, if every five years or so the share market is at another "all time high"? It sounds so easy, and when we're looking backward from a great advantage point (as we are in the USA today), it's easy to agree with Mr Buffett but, when we're at the bottom of the cliff just after the market tipped us over the edge, most wish for a better crystal ball or an “active” Fund Manager that was “underweight” in the markets before they fell, and minimised the loss.
This debate about "active" vs "passive" will be calmed when the market next falls, because good Active Managers “should” hold their ground better than the index. However today that may mean those Active Managers will struggle to outperform that same index. If we think about it, when the market is racing ahead and the “expert” we pay to guide us is fearful that stocks are now expensive, surely they will invest more capital into cash or alternative assets? Therefore, it stands to reason that they will “underperform” the market (because they’re not fully invested). The idea is, when the market does fall the Active Manager’s return may not fall as far, providing they’ve invested well. Their recovery may then also occur sooner, or at least that’s the plan.
In 2017, markets are at an all-time high & indices have outperformed most managers, but not all active managers are investing actively away from the index. The majority still hug the index.
Remember, nearly all Fund Managers are “active” managers. Indices are not people, they’re the market. As an Investment Advisor, we choose which Managers to engage. Indeed I would suggest that most Fund Managers don’t get onto our recommended product lists. When the next big fall in markets occur, these active index huggers (the 85%) will likely fall by the same degree as passive funds and in that regard, the investor paid active fees for passive performance.
Is now the time to be investing in Passive/Index funds?
In most of our strategies the dominant global managers deployed have been Platinum and Magellan. Both are "active" and both have underperformed global share markets at different times recently. Here are the facts:
Fund (to 31 May 2017) 1 year 3 year 5 year 10 year
Magellan Global 12.9% 15.3% 18.8% 11.5%
Platinum International 17.8% 12.4% 17.2% 8.0%
MSCI – Index (passive) 14.3% 13.4% 17.5% 4.7%
The fund performance is pa after fund manager fees. The MSCI is the index. However a passive index fund like say a Vanguard Global fund would have the performance of the index but fees of between 0.2% - 0.4% would yet need to be paid.
The post fee returns between the “active” managers we deployed and the “passive index” against which they are measured, are very close. In that regard, there isn’t a lot of return “value” added by the “active” managers these last five years and so why would investors pay higher fees to have an “active” manager if there is so little in it? I’d suggest that not all “active” managers are equal.
We know markets move in cycles and a cycle is usually three to five years. If we look past the last five years (to ten years) and take into account a couple of the big market falls that happened, we can better test, if “value” was added by our managers. Look at that ten year number on the far right (above). It’s fairly compelling and remember, it’s post fees. Magellan is the clear winner (by some degree), but past returns are no guarantee of future returns.
Can we be sure that our “active” choices will perform over the next ten years? No! We can conclude that some Active Managers do earn their fee, despite what the media says but, it takes time for that to reveal itself - just as Berkshire Hathaway took 51 years to prove Warren Buffett had a talent for picking good businesses (but you know, he didn’t always get it right either).
Platinum have been the prominent Active Manager I’ve used since 1995. They have been in my portfolios to varying degrees for twenty two years. Very often they have not been the best performer – as evidenced these last ten years (Magellan beat them convincingly, though they still achieved a return after their fees, which was nearly double that of the passive index alternative).
While we can’t predict what tomorrow brings, we can show what has historically been the result for our investors who followed our advice into a fund twenty two years ago (as compared to a passive index fund):
Fund 22 years Value of $100,000 invested
Platinum International (since inception) 12.88% $1,437,388
MSCI – Index (passive) 6.63% $ 410,531
Returns are net of management fees but before tax (if any) and in these examples, reported in AUD
This debate is historical; we now need to concern ourselves with what will happen tomorrow…
I believe we should have both active and passive strategies in our portfolio. We engage a number of direct share investments; so, is that approach “active” or “passive”?
We tend to buy and hold quality companies (shares) and in that regard, it is passive, but we then have the concentration risk of investing in those businesses, which I’d suggest is more active.
We have had very good and measurable success from this approach of engaging direct shares and it suits the many professional people for whom we act but, I’m beginning to give stronger thought to capturing more “passive” funds – more index related holdings. I’m also a little fearful around the timing of that exercise because, while we acknowledge that passive funds charge fees which are approximately a quarter of the active managers, the evidence above still supports active managers, if we get our Fund Manager selection right.
We can’t guarantee that we can pick them right all the time and we also know that the bigger the active manager gets (the more funds under management they have), the less they seem to outperform their relative index. Size begins to hamper their ability to be nimble. So, it’s complicated and even then, there are exceptions (Warren Buffett’s a fairly good example of an “exception”).
We do need to have a number of different investment baskets, all working together for the benefit of our investor and there are many parts to managing an effective portfolio.
One final thought…
A year ago the MSCI (Morgan Stanley Capital Index) – against which most international Fund Managers measure themselves, reflected the US share market as representing 52% of that index by itself (NZ makes up just 0.50% of the world index).
As at May 2017, the US share market now represents 59% of the world index and almost every commentator agrees, one of the most expensive share markets in the world today is the USA! Many also agree the USA has still much opportunity ahead and so, we are in the very normal position of not really knowing if prices are now “too cold”, “too hot”, or “just right”.
In the context of the last six years (current bull market), one does have to wonder if the majority of the return from this “cycle” has already occurred? So, are we still content to be in an investment vehicle that places nearly 60% of the underlying investment emphasis into expensive US shares?
The argument around “Active” or “Passive” is good to have and for investors to have choice is better still. In that, I’m looking at index funds (ETF’s) as an option to gain a cheap exposure to a market; and thinking of places such as India, or sectors such as Healthcare or where we may find Disruptive Technology. Maybe an “active / passive” option is a better strategy, if we still believe it’s possible to get an edge by doing good research, or by simply still having a strong gut feeling.
In conclusion, I think there is room for both Active and Passive, but when perfect hindsight reveals that over a decade, the active manager we engaged delivered a return of 10%p.a (after fees of 1.5%p.a) and the passive index which charged way less (0.20%p.a) delivered 5%p.a, the debate quickly dies… except to acknowledge; “Past returns are still no guarantee to future returns”.
Tony Munro CFP AFA
The views and opinions expressed in this article are intended to be of a general nature and do not constitute personalised advice for an individual client.
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