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).