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Active versus passive: tracking the latest twist in the tale

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Active versus passive: tracking the latest twist in the tale

The active versus passive fund management debate has heated up once more. The passive camp was quick to jump on data to support its cause, but further analysis revealed a compelling counter case.

Contradictory conclusions

A recent study by S&P Dow Jones Indices appeared damning of actively managed funds. The analysis outlined widespread underperformance of active funds, with 86% of active equity funds in Europe failing to beat their benchmarks in the past 10 years.

So far in 2016 actively managed equity funds have faced net outflows of $34.9 billion (£24.7 billion) compared with $7.5 billion taken in by equity exchange-traded funds (ETFs).

Research from Citywire, however, offers a different view. We pull together the performance of fund managers as they move companies, as long as they remain in the sector. On this basis, 68% of equity fund managers in the UK All Companies sector outperformed their benchmark over 10 years.

Market efficiency

A broader, and perhaps fundamental, point in defence of active funds is made by Aneel Keswani, director of the Centre for Asset Management Research at Cass Business School. He said financial markets would be inefficient without active trading.

‘Passive funds are free riding on the trading behaviour of active funds,’ said Keswani. ‘If everyone tracked an index, what trading would you get? You wouldn’t get efficient prices.’

In other words, effective active investment is a prerequisite for effective passive investment.

George Luckraft, lead manager of several AXA Framlington income funds, said there was a natural balance between how much was allocated to active and passive funds.

‘If you get too much passive, then markets become inefficient, opening opportunities for active managers,’ he said. ‘As that cycle happens, active fund managers attract more money and it becomes harder for them to outperform.’

So an increase in the popularity of passive investment could in itself lead to passive equity underperformance.

He also said going into passive investment at market extremes could lead to poor performance. ‘If you went into the market at the peak of the tech bubble, you would have had lots of exposure to technology,’ he said.

The academic view

There is academic support for Luckraft’s perspective in a 2012 paper, Time-Varying Fund Manager Skill by economists Marcin Kacperczyk, Stijn Van Nieuwerburgh and Laura Veldkamp.

The authors said: ‘We find evidence for stock picking in booms and for market timing in recessions. Moreover, the same fund managers that pick stocks well in expansions also time the market well in recessions. These fund managers significantly outperform other funds and passive benchmarks.’

Peter Elston, chief investment officer and multi-asset specialist at Seneca Investment Managers, is another supporter of active funds. ‘In my view, government bonds are very expensive. At some point they will start to perform poorly and therefore you want to be in an active multi-asset fund that can avoid them,’ he said.

Advisers on both sides of the fence

John Chadwick, managing director of Chester-based Chadwicks, said he felt uncomfortable with passive funds, which ‘by their very nature include holdings you wouldn’t otherwise want in your portfolio’.

But not all advisers are convinced. Peter Griffin, investment director at Yorkshire and London-based Gale and Phillipson, makes extensive use of passive funds in the firm’s discretionary fund management service.

He said the selection of passives is down to the asset allocation decisions of the internal investment team and this is an active investment process.

‘We use passives for all equity exposure but actives for property and absolute return funds. We do constantly try to be aware of active/passive split,’ he said. ‘We are doing research on how we think active funds would have done in the past few years, then will review on a regular basis to reassess our approach.’

There is no denying some active fund managers have performed poorly, allowing charges to eat away at returns. However, there is a danger of throwing the active fund management baby out with the bathwater.

Keswani said: ‘The more data you have on consistent fund manager outperformance, the more confidence you can put on your belief that a manager has skill.’

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George Luckraft
George Luckraft
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