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Passive versus active: betting against the house

Passive versus active: betting against the house

It has been broadly shown that, in general, passive strategies outperform active strategies for broad market indices.

As followers of academic work and ‘evidence’, where it is available, at Thurleigh this argument should direct us into the arms of passive securities.

Yet paradoxically, today we find that we have our highest proportion of active equity funds versus passive equity (see chart one).


Our reasoning for this is that that we are trying to overweight a specific type of company: global firms with earnings linked to consumer growth in industrialising nations.

Passive contenders in this area include the ‘Aristocrats’ and ‘RAFI’ indices, but we went for active providers, such as the Morgan Stanley Global Brands fund, because we were nervous of the ‘blind alleys’ that indices can sometimes throw up.

So, have we fallen into the classic trap of thinking that we can beat the index?

First of all, ‘blind alleys’. What we mean by this is that the more rules that an index has to conform to, the higher the chance that something unexpected might happen.

We know of a dividend-based index that had turnover of securities of more than 30% in 2012, meaning that the securities it owned at the end of the year was very different to those held at the start – and doubling its average market capitialisation in 12 months.

Another important point is that bubbles or investment manias distort indices. In the decade to 2000, the S&P 500 weighting in information technology grew from circa 10% to just under 30% (source: State Street).

In the summer of 2007 the FTSE 100 had 28% in financials (source: Bloomberg). Neither of these ‘super-weights’ did the index any favours – indeed, the FTSE weighting in financials had fallen to 16% less than two years later.

In such a period, it might be hoped that active managers in aggregate would outperform their passive counterparts.

Neither the bursting of the technology bubble nor the collapse of financials happened overnight, and while the index is tied into its allocations, active funds are, by definition, not.

Indeed, in extreme situations indices can be ‘whipsawed’ in the same way as active managers – stocks can fall so far that they fall out of indices, which means that any rebound may be missed.

Unfortunately, the evidence doesn’t immediately support this. As shown in chart two, the rate of outperformance of active versus passive in both 2000 and 2007 is a little, but not significantly over the average.

Even more depressingly, from 2000 to 2008 on average only 37% of active managers outperformed their passive counterparts in any given year. Of course, some of the active outperformers are very large funds.

This brings us back to the question of whether we are just kidding ourselves with our unusually high ‘out of index’ allocations.

I think that the answer must be that, as unconstrained asset allocators, our choices are bound by our desire to make the best possible returns for our clients with a given amount of risk.

Where we cannot find an index that fits our asset allocation choice, we must turn to active managers, even in the knowledge that both higher costs and historical precedent are against us.

So far, so good: our active choices have, over the past year, given us roughly 5% over our default choice, an MSCI World index tracker, admittedly with a certain amount of tactical trading. For now, we will continue to bet against the house.


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