The case for active investing
Investors seem to be voting with their feet. The scale of the recent shift of money from actively managed funds into those that track market indices has become hard to ignore.
According to data from specialist information provider analyst Broadridge, nearly $2.4 trillion has flowed into passive exchange-traded funds (ETFs) in the US over the last 15 years, while $500 billion has moved out of active funds.
This trend is held up by many commentators as decisive proof of investors’ belief in the superiority of passive investing over the skills of a fund manager. But seemingly unstoppable investment trends have a habit of reversing unexpectedly.
We argue that, before rushing to conclusions, investors should take a long hard look at both the data and what so-called “passive” funds actively offer.
Ultimately, we think both have a place in portfolios, but it’s in the interests of investors to strike a balance between the two and use each method when and where it is most appropriate. The research we have undertaken recently certainly suggests that investors should keep an open mind.
A Sharpe definition of active management
The classic academic view of active management was proposed by Professor William Sharpe, who argued that, “after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar”.
In reaching this conclusion, he assumed that the index represented the entire range of investment opportunities, and that all participants were motivated by the same objectives.
In truth, for many investors, an index return may not coincide with the outcomes they are seeking. For instance pensioners needing to create a secure income in retirement.
Since Sharpe, many researchers have demonstrated that markets are less efficient than once thought, and that investors’ behavioural biases and irrational decisions create opportunities for active managers.
Markets have also become distorted by the actions of central banks, buying bonds in quantitative easing programmes, or by governments owning stakes in companies.
Some markets are more efficient than others, but conclusions are often transferred from one to another. We have analysed the data on different markets.
How data is used in the active/passive debate
Data from SPIVA, part of S&P Dow Jones Indices, is often used in the passive-active debate. A recent SPIVA (S&P indices versus active) report stated that over 88% of large cap equity funds in the US underperformed the S&P 500 Index in the latest five-year period.
In the case of large cap US equities, this conclusion is reinforced from other sources, but there are weaknesses in the SPIVA methodology.
It assumes any fund which has closed or been merged into another fund has underperformed. This assumption is not universally valid. We tested UK stockmarket funds that had closed in the past 10 years and found that 20% had outperformed before closure.
SPIVA also picks its own S&P index for each fund comparison rather than the actual index a fund has set out to beat.There is a tendency to extrapolate from the US market the conclusion that other equity markets are hard to beat.
But the US is different – institutional ownership, particularly by home-grown institutions which are more familiar with domestic securities, is significantly higher than in other countries. The US, therefore, is a more efficient market.
We looked at performance in other major markets. But rather than assume passive performance is the same as the market index, we have used a more realistic comparison – ETFs.
These bear real management fees and trading costs, which an index does not. The results, below, suggest that in many markets the argument that most active funds underperform is far from clear cut.
A realistic reflection of investors’ experience shows active in a better light.
ETF cumulative returns vs. benchmark five years to 31 March 2017
Returns are shown in US dollars except for UK equities in sterling. Includes actual performance of funds closed and opened during the period. Source: UK equities - iShares Core FTSE 100 UCITS ETF; Emerging market equities - iShares MSCI Emerging Markets ETF; Eurozone equities - iShares MSCI Eurozone ETF; Japanese equities - iShares MSCI Japan ETF; Global bonds - Vanguard Global Bond Index fund (Institutional hedged – US dollars); US high yield - SPDR® Bloomberg Barclays High Yield Bond ETF; Emerging market bonds - iShares J.P. Morgan USD Emerging Markets Bond ETF. Past performance is not a guide to future performance and may not be repeated.
Drilling down further, we looked at how active performance has varied over time in the UK and emerging markets. We looked at monthly excess returns after fees – in this case against the index.
Unlike previous studies, we included only funds that are benchmarked to a broad index. By doing so, we excluded the funds that are either not benchmarked, or funds that employ a specific strategy, such as sustainability or special situations.
The charts below show the percentage of active funds in the UK and within emerging markets that have outperformed their benchmarks on a rolling five-year basis. Only funds that have a full five years of performance history at a given date were included in the calculation.
Data from the UK shows that the performance of active managers is cyclical, but that there have been several periods, including the present, when well over 60% of active funds have outperformed net of fees.
The second chart shows a similar pattern for emerging markets equities, with active performance improving steadily since 2008.
Active performance has improved in the UK…
UK percentage of funds outperforming (rolling five years)
Investment Association primary retail share class active UK equity funds domiciled in the UK in sterling. Source: Morningstar. Data to March 2017. Past performance is not a guide to future performance and may not be repeated.
…and among active emerging markets funds
Percentage of emerging markets funds outperforming (rolling 5 years)
Active EM equity funds domiciled in the US denominated in US dollars; retail share class with longest history. Source: Morningstar. Data to March 2017. Past performance is not a guide to future performance and may not be repeated.
There is also good evidence that managers who perform well over the longer term experience significant periods of underperformance in the short term.
The Vanguard Group published a study in 2015 which showed that, of the 552 active US equity funds that had beaten the index over the previous 15 years, 98% had underperformed in four or more individual years.
The implication is that investors are more likely to achieve good outcomes if they do not abandon a strategy after a short period of underperformance.
Another important consideration when considering passive investing is fees. We measured active performance against indices net of fees, which penalises performance as the index bears no costs.
Assuming a 0.30% average annual passive fee for UK equities over a 26-year period, the passive fund would have trailed the benchmark by 8%. So while many active funds may have underperformed the index, 100% of passive funds have underperformed.
The point about measuring the real cost of passive management is most visible in emerging markets, where the costs of acquiring market exposure have been higher (until recently typically 0.75%) than in developed markets.
Of course, the cost of passive has fallen significantly in the last few years, raising the standard against which active managers will be measured in future, but in many markets passive costs are still material.
The advantages of active in bond investing
A passive bond fund tends to allocate money based on the amount of debt issued.
In the case of a government bond fund, this could result in investors being directed towards governments with debt problems. In developed markets, this could mean investing large amounts in Italian bonds; in emerging markets, Venezuelan bonds. There is little logic to this approach.
In addition, new securities, which typically make up 20% of bond market capitalisation in a year, have to be included in bond market indices. This is far higher than in stockmarkets and will inevitably raise trading costs. As a result, passive bond funds can significantly underperform their indices, as the table below demonstrates.
Two large bond ETFs have consistently underperformed their indices.
The two large bond ETFs that have underperformed
Chart shows annualised returns in US dollars to 30 April 2017, net of fees. The Bloomberg Barclays High Yield Very Liquid Index is the benchmark for the SPDR Bloomberg Barclays High Yield Bond ETF (JNK). The Global Core Index is the EMB fund's benchmark. Source: Bloomberg, iShares, JP Morgan and SSgA. Past performance is not a guide to future performance and may not be repeated.
The roles for active managers
An increasingly important issue for individual savers and pensioners is the real world outcomes they want. It is questionable to what degree passive can help in this regard.
For example, as discussed earlier, many people simply want stable and reliable income in retirement. For these investors, success is likely to depend on allocating to the right asset classes.
This cannot be done passively. There is no index that can be aligned with a real world outcome, such as growing an investor’s money in line with inflation and still achieving income of 4% a year.
A newer dimension in the debate is the rise of “smart beta”. Instead of following a traditional index, based on market capitalisation, these passive funds select shares based on other criteria, such as yield or volatility.
A mix of these strategies has beaten index returns over the past 15 years and done so more cheaply than traditional active management. Even so, getting the best out of smart beta strategies will require decisions to be made over which ones to use and when.
These are decisions that cannot be taken “passively”. It is an active skill.
The unseen benefits of active management
It is also worth considering the role active investors play in the broader economy and society. Without active managers, asset prices would be based purely on the market size of companies, meaning there would be no mechanism to deploy capital in the best places and maximise returns for the benefit of the whole economy.
There is already evidence that recent large flows into passive funds are leading to distortions in markets.
We would contend that the stewardship activities of active investors raise returns in the capital markets by encouraging higher standards of corporate governance and directing capital into faster-growing industries.
This is a role governments in both Europe and Asia are encouraging. In Japan, in particular, policymakers are keen to see stewardship lead to better capital allocation, and everywhere managers are expected to exercise their voting rights responsibly.
There is a danger that, where active management has not met expectations, investors feel that they should abandon it altogether. But closer analysis of the data suggests many investors in active equity strategies have beaten passive funds after fees.
It is true that the characteristics of the US equity market make this the hardest market to beat. But we believe it is incorrect to extrapolate from the US to other equity markets, where there is no evidence that active performance is on a secular downtrend.
In bond markets capitalisation-weighted indices are both illogical ways to invest, and hard to track. And for investors who need to achieve a particular outcome, passive can be an impractical solution.
Moreover, active performance is cyclical. Active managers fare better in some environments than others, and selling out of a manager with a strong philosophy and process after a short period of underperformance risks locking in underperformance.
Investors need to use all the tools available to them: active, passive and smart beta. We would argue that the potential value added from active management remains critical to maximising the return from a broad portfolio, meaning that active management will in time start to regain share from passive.
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