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Active fund manager praises passive index investing as a ‘force for good’

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By Maja Garaca Djurdjevic
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4 minute read

An active fund manager recently hailed passive index investing as a “great force for good”, yet emphasised that human insight still surpasses algorithms in the investment realm.

Despite his active management background, Steve Johnson, founder and CIO at Forager Funds Management, highlighted the positive impact of passive index investing in reducing fees and enhancing market efficiency during a discussion on the Relative Return podcast.

“I’ve been kicked out of the active fund managers club for saying this, but I think it is a great force for good,” Johnson candidly admitted, expressing concern about the inefficiencies and high fees associated with “actively passive” fund managers. These managers, he explained, often replicate indices closely without adding significant value, leading to wasted fees.

“There were a lot of fees just being wasted on what I would call, maybe actively passive is the best way of putting it – fund managers that get so big that you almost have no choice but to go pretty close to replicating the index, don’t add a lot of value and charge a lot in fees,” Johnson said.

Elaborating further, Johnson emphasised the mathematical logic behind index investing, particularly in large blue-chip companies, calling it “fairly irrefutable”.

Pointing out the fee structure dilemma faced by active managers, where charging a percentage annually can significantly erode returns, especially in larger-cap funds, Johnson said: “You’re saying, well, 16 per cent of the return here is going to the manager, and they can only invest in a pretty small subset of stocks because they’re so big.

“I don’t think you’re going to see large-cap funds outperforming index funds over long periods of time, probably ever, just because of that dynamic around fees. I think at the small end of the market, we’ve had a very significant and now, I think, self-fulfilling period of underperformance.”

However, Johnson is optimistic about the potential for active managers to add more value as computer technology increases its role in investment management.

Namely, while highlighting the growing influence of computers and algorithms in investment management, Johnson explained while human investors cannot compete head-to-head with modern supercomputers in terms of speed and accuracy, the enduring value of human insight is key.

“In some ways, I think the computers and the passive funds are exacerbating these short-term swings in markets, whether it’s related to interest rates or bull markets and bear markets,” he said.

“You just think back over the past five years, even within the course of a 12-month period, you’re getting markets down 20 per cent and then up 30 per cent. And I think the human psychology element to what we do, the ability to look further out than the short-term fear that people are feeling, for me, is one of the most important bastions of active management in terms of what we can do,” Johnson explained.

Moreover, he emphasised the importance of human psychology in investment decisions, which remains a critical aspect of active management.

“Unless we have a really good understanding of why the market is pricing a stock low, I don’t think we should be buying it as a business. You can do all of the numbers and all the calculations and all the models that you want, but our whole process is built around understanding what’s happening here that’s creating some inefficiency for us to be able to go and buy this business.

“Because if it just comes down to analysing the P&I and a balance sheet, and the financial statements, there’s a computer out there that is going to do that just as well as us. So, we put a huge amount of time into it. And I think encouragingly, it’s only getting more extreme in terms of people panicking and deciding they don’t want to be in the market, and they do want to be in the market or even within certain sectors.”

Ultimately, while a champion for passive index investing, he sees irreplaceable value in human insight and the importance of understanding market psychology – something computers cannot yet do.

To hear more from Johnson, click here.