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Active versus passive: weighing up the evidence

David Bassanese
— 1 minute read

The strong growth in index funds and ETFs in Australia is stirring debate about the benefits of active versus passive investment management, says BetaShares’ David Bassanese.

David Bassanese

Some commentators have suggested that index-oriented investments are merely for ‘dumb’ investors, who have no real skills in picking mispriced securities likely to outperform the market.

If this were true, it would follow that these investors are leaving money on the table as by either investing in the development of these skills – or hiring talented active managers – they could produce better returns.

It has been suggested that over the very long run, ‘sensible investing’ in ‘quality’ stocks ‘will beat an index’. How true is this? (Spoiler alert: the evidence suggests this is not true!)

Fortunately for participants in the perennial active/passive debate, whether active managers can outperform a market-cap weighted index is ultimately an empirical question.

On this score, the evidence seems overwhelmingly in favour of passive investment – both in Australia and overseas.

According to the latest SPIVA Australia Scorecard by S&P Dow Jones Indices, for example, a full 78 per cent of active Australian general equity managers underperformed the S&P/ASX 200 Index over the five years ending December 2014.

The performance of local international equity managers, Australian fixed-income managers, and listed property managers was in fact somewhat worse.

Over the latest three-year period, the scorecard was slightly better for Australian equities active managers, although six in 10 managers still underperformed.

Even if active managers were able to consistently outperform the market, moreover, their degree of outperformance would need to exceed their management fees to beat some of the very low cost ETFs and index funds available.

As but one example, a fund that charged a one per cent per annum management fee plus a 10 per cent outperformance fee would need to generate a return of 10.95 per cent per annum to offer the same return to an investor in an index product that rose by 10 per cent in the year and charged a management fee of 0.15 per cent per annum.

Of course, the evidence suggests that some active managers can outperform the market. The only challenge investors face, therefore, is in identifying these superior managers.

The problem, however, is that actually picking active managers that consistently outperform is not as easy as it seems.

As the old truism goes, past performance is not a great indicator of future performance.

How well do active managers perform?

Mercer recently produced some research on Australian active equity managers which tracked the performance of investment managers across two three-year investment periods.

The question is: how many of the funds that performed well in the first period also performed well in the second period? In other words, how persistent was outperformance?

It turns out that only 24 per cent of the 29 funds identified by Mercer as enjoying top quartile investment performance in the three years to September 2010 were also able to produce top-quartile performance in the three years to September 2013.

In fact, statistically speaking, the most likely scenario (31 per cent) is for a top quartile performer in the first period to end up becoming a fourth quartile performer in the second period!

Meanwhile, almost one in five of these top performing funds ceased operation (or were merged/taken-over) in the second three-year investment period.

Indeed, according to the Mercer survey, of the 32 funds with top quartile performance in the three years to September 2013 (among 126 funds covered), 16 – or 50 per cent – of these funds were new to the market.

Due to the fact that institutional money – which is still predominantly active in nature – tends to dominate ownership and therefore trading in the Australian equity market, it stands to reason that not all managers (who effectively “are” the market) can outperform the market all of the time.

This is because for every ‘winning’ trade, there will equally be a ‘loser’ on the other side.

Of the $1.6 trillion worth of “listed and other” equities in Australia as at end-December 2014, a whopping $1.4 trillion – or 83 per cent – was owned either by domestic institutional investors or foreign owners (which are also largely institutional).

Households directly owned only around $200 billion or 13 per cent. With active managers owning around 80 per cent of the market, their collective attempt to beat the market is akin to a zero-sum game.

Building ‘smarter’ indices

Due to the development and continued innovation in indexation, there are now a number of indices which recognise the limitations of traditional market-cap weighted indices.

These ‘smart beta’ indices, such as, for example, fundamentally weighted indices, combine the benefits of index funds (ie. low cost, transparent, diversified, rules-based) along with the potential to outperform the market-cap benchmark.

There has also been some conjecture that the continued growth of index investing and ETFs may contribute to potential market distortions.

But the truth is we’re a long way away from that.

According to Morningstar Research estimates, passive investment strategies have accounted for around eight per cent of the Australian managed funds industry in recent years – at these levels it’s unlikely rebalances in such products will be a major influence on market pricing.

With only $18 billion funds under management, ETPs account for only around 0.7 per cent of the $2.4 trillion managed funds industry as at March 2015.

That said, even in the United States – where passive investment is estimated to account for a much larger 24 per cent of funds under management in 2013 – it still seems evident that active managers have a hard time beating the market.

According to S&P’s latest survey, for example, 88 per cent of large-cap US managers failed to beat the S&P 500 index in the five years to the end of 2014.

With all that said, there is no doubt that there does exist a select number of active managers who have a strong track record of persistent outperformance.

At BetaShares, we firmly believe that active management has a role to play in investors’ portfolios, and often find ourselves discussing how ETFs can be used in combination with high quality active managers.

However, when considering the active versus passive debate, we believe it’s important to be armed with the empirical facts.

David Bassanese is the chief economist of ETF provider BetaShares.

 

Active versus passive: weighing up the evidence
David Bassanese
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