A number of eye-catching recent statistics have reignited the ongoing debate around active vs. passive investment. Passive funds now account for 35% of all mutual fund assets in the US, up from just 2% 20 years ago. As illustrated in the Financial Times charts below, in 2014 less than 15% of US large-cap mutual funds outperformed their benchmarks, marking a low point for an industry under increasing scrutiny.
When even Warren Buffett is telling his wife to put 90% of his fortune into an S&P 500 tracker fund after he dies, it’s difficult not to pay attention.
Morningstar recently posted an interview discussing some of the key reasons behind the growth of passively managed funds during the last 12 months. The 3 main themes highlighted are:
- Lower-cost products
- Wider choice of index funds
- Strong global index performance
To a certain extent, these themes go hand in hand – the better the main indices perform, the more interest passive funds generate and the more products are tailored around them. With returns under greater scrutiny than ever, the cost advantage to index investing from a fund management point of view looks increasingly attractive to investors.
Vanguard’s own blog puts the role of these costs into perspective. Given the small margins, reducing the execution cost of the actively managed fund significantly increases the likelihood that it will outperform the benchmark. In fact, for funds with a cost lower than 50 bps this number rises to 39%.
Perhaps inevitably, 2014 saw a substantial increase in the prevalence of alternative investment strategies such as smart beta. These strategies are a logical half-way house, offering investors the lower-cost security of index investment with the flexibility of an active weighting strategy. It may be too early to evaluate the long-term success of this approach, but after such a difficult year in the press, active fund managers are increasingly taking advantage of the additional opportunity to demonstrate that skill still has a huge role to play in chasing alpha, even if this does herald a more general trend towards cost reduction across the investment management industry.
Many have pointed to the dubious practice of ‘closet tracking’ as a drag factor on active investment return figures. Closet trackers are actively managed funds which track the index either entirely or to a significant extent, meaning that investors lose out on both counts, as they are charged high fees for what are effectively passively managed funds. In fact, Informed Choice point out that over three quarters of the IMA UK All Companies sector funds correlate with their benchmark index to a degree of 90% or more. An FT article recently highlighted that as much as a third of actively managed UK funds can be classified as such. Some correlation is probably a good thing, particularly given index performance in 2014, but given the higher fees there comes a point where it makes more sense for investors to bypass the middleman and go straight for the index.
The case for active management
Active and smart beta funds still offer some obvious advantages over their passive counterparts. A Times article published on Saturday cites a study by HFM Columbus which suggests that active funds in the UK have actually prospered during the last 12 months, although the study does not take into account the execution costs of the respective strategies.
The article highlights the fact that control over investment provides protection against macro industry trends such as the falling oil price, as the performance of companies like BP and Royal Dutch Shell drag indices down and provide the active fund manager with an opportunity to outperform. The strong performance of small- and mid-cap stocks in 2014 also offered investors a good alternative for getting ahead of the market. Skilful fund managers continue to exploit this opportunity to good effect to stay ahead of their benchmarks. As the Novel Investor chart we posted up over the weekend shows, emerging market equities are the other big performers as an increasing number of active fund managers look internationally for value. Opportunities are often found within segments of the market not covered by mainstream research analysts.
The wider performance margins emerging markets and SMEs offer can reduce the impact of execution costs for high return funds (the impact of macro trends can be similarly amplified). The higher volatility of these stocks coupled with a more lenient disclosure environment and an often unpredictable economic or political climate means that it’s particularly important for investors to be actively engaged with the companies in their portfolios, and to stay on top of and react to the latest developments to maintain an edge over their passive rivals.
If they can manage this, 2015 may yet be the year of the active investor.