Passive versus active: betting against the house

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.