Funds part 2: Active vs Passive

You may have been left pondering what these terms mean recently as “return of active management” is discussed in the news. Active and passive management refer to two methods used to set up and manage the portfolio of an equity fund. Active requires the fund manager to research shares on an individual basis in order to make and execute decisions on which ones to buy or sell and in what quantities. In taking advantage of the supposed difference between a share’s true value and its market price, active managers aim to “beat the market”. This means to get better returns than the market index it is trading in. For example, a FTSE250 active fund’s aim will be to provide its investors with better returns over its life than that of the FTSE250 as a whole. It is hoped that through expertise and research, the fund manager can pick the winning shares and avoid the losers. For example, an active fund trading shares in the EQ100 index has 10% of its money invested share A, yet this share’s market cap only makes up 5% of the EQ100. Assuming that everything else stays the same, if share A rockets in price, the fund is more exposed to this than the market index. Therefore, the active fund will benefit more from share A’s performance and therefore has beaten the market. This stockpicking activity in order to actively beat the market is where the fund manager claims to be earning his fee. The word active has cropped twice in one sentence and so explains the name “active management”. It can also be referred to as stockpicking or traditional asset management. The stereotypical image of an asset manager sealing trades with a handshake over lunch, and charging loads of money for the pleasure, depicts the active method. This contrasts with passive management.

Passive management is basically lazy portfolio management, hence “passive”. Funds are set up that hold all or most of a particular market index in the correct quantities in order to mirror the index. For example, a FTSE 100 passive fund will try to hold all the shares in the FTSE 100 in the same proportions as their market caps. For example, imagine market index SP3 contained three shares with the following market caps: share 1 – £30 million market cap, share 2 -£15million market cap, share 3 – £5 million market cap. The total market cap for the index is 30+15+5=50million. Of which, 60% is represented by share 1, 30% by share 2 and 10% by share 3. A passive fund tracking this index would use its available money to purchase the shares in the same proportions: share 1: 60%, share 2: 30%, share 3: 10%. This funds’ performance now mirrors that of the SP3 index exactly, which explains why they are also called index funds as well as Exchange Traded Commodities (ETFs). As you can see, no research or decision making is required, the fund is simply mimicking the index. The passive faithful believe in the Efficient Market Hypothesis (EMH). This is the theory that it is impossible to beat the market because all information effecting a stock is already factored into its price. So, you can’t beat the market price because even if you know something or you’ve done some research, you would pay a price that already reflects the implications of your information or research. Basically, if a share is priced at 100p, then it is worth 100p and that is final so stop arguing, ok? There is no difference between the price and the true value of the share and so there’s no wiggle room for a stockpicker to make a buck. The lack of human input required in passive funds has meant they can now been produced and maintained by clever algorithms and computers. This translates to lower operating costs and therefore lower fees for investors in the fund. Furthermore, holding all of the many shares in an index which operate in a broad range of industries provides the fund with diversification and therefore reduced risk.

Since the turn of the millennium, passive funds have been increasing in popularity as the majority of active funds have failed in their quest to beat the market, making their high fees unjustifiable. Over the last ten years 83 per cent of US active funds have lagged behind their market index, while 40 per cent have had to close prematurely as performance was so bad (Financial Times, 2017). Ultimately when investing in shares, your profit comes at the expense of other investors. A share’s value is a result of market consensus, i.e. its worth as much as everyone collectively reckons its worth. You may buy a share because you think it’s future growth potential means it is currently undervalued, so you’re presuming everyone else has overlooked this. For an active fund manager, its the same, they are competing against other investors and to beat the market they must come out on top. In the “good old days” a fund manager may have used their connections or skill to acquire information not yet known by the broader market. Allowing them to act on its implications to the share’s value before it was reflected in the market price. This is becoming increasingly less possible as a faster and more sophisticated network of information becomes more available to all investors thanks to technology advancements and more regulation and researching effort. It has become harder for the active fund manager to find the edge over everyone else, as everyone is more equally equipped. Furthermore, when a broker gives you a quote for a share, a lot of calculation has gone into determining that price at that particular moment. This is otherwise known as price discovery and incorporates many factors such as supply, demand and risk. Active fund managers use to be able to exploit variances and inaccuracies in price discovery. Yet, the technology and resource behind this practice have increased greatly since and so this avenue is being closed off to them. Institutional investors are professional entities that pool money together from their members and invest it on their behalf. They can be mutual funds, ETFs, investment banks, pension funds, hedge funds, insurance companies… basically everyone except for poor little hobbyist investors like you and me.  When active fund managers, who themselves are institutional investors, had their hay day back in the 60’s and 70’s, these investors only made up 5% of the investor base. Institutional investors are much better equipped with more time and resource and therefore I’m afraid tend to be better at it than us. Don’t feel bad though, trading on your iPhone during your lunch break is a bit of an unfair comparison to a global investment bank like BlackRock or Goldman Sachs. If you recall, all investors are effectively competing against each other, so it’s no surprise that institutional investors found it easy when they were up against us everyday joes. These days however institutional investor make up 95% of the investor base which means they are predominantly competing against each other, equally well equipped and expert investors, which is proving harder.

Low volatility has been a consistent feature of global markets in the year as they have consistently climbed. The active manager was even more redundant because when everything’s going up its quite difficult to pick a loser isn’t it? So, why would you pay for an expensive stockpicker? Especially when tracker funds are piggybacking great market wide performance for lower fees and risk. However, as you probably know, since the turn of the year markets have been all over the place and have dropped drastically. All of a sudden, shares can swing wildly during the day and their performances are much less uniform. So, people are arguing that this is the active fund manager’s opportunity to return and prove his worth. A knight in a shiny suit navigating through treacherous markets using expertise and skill to dodge the biggest fallers and pick shares going against the grain. This has prompted some active funds to pop up again along with their high-profile managers, such as “The Wizard of Oz” Gregg Coffey.

This phenomenon is not new, historical trends suggest that the performances of active and passive funds are cyclic, which means they follow a repeating pattern. Falling markets and periods of high volatility such as the dot com bubble at the turn of the millennium and the 2008 financial crash see active funds perform better than passive. As discussed, this is because selectivity is needed to pick the shares faring better than the struggling overall index.  2018’s sell-off has been caused by a shift in global macro-economics, which I explained in my last article. So, if we are entering a sustained sell off or volatile period, active fund’s performance should pick up and perhaps outperform their passive counterparts. The general consensus however, is that the rocky start to the year is merely a correction and not the start of bear run, so it is unclear whether this volatility will last.

While, this correction should breathe new life into active funds, the underlying reasons driving the rise of passive management are here to stay, technology isn’t going to halt its advance. It is unlikely therefore that active funds will ever return to their prominence or performance of the 70s and 80s. Yet, the cyclic nature of equities markets mean volatility will always return and therefore there will always be some need for the stockpicker. This is why when choosing funds it is important to diversify with a balance between the two styles. However, it may be wise to consider passive as your bread and butter, especially if you’re investing on a budget.

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