Active versus passive investing: which is better?

 

The stock market often appears to be a complex and risky place in which to invest money. The latter is of course correct: there is risk in almost any action, even inaction carries risk of some sort.

Therefore a huge industry has been created over the past century, where experts (fund managers) offer to take care of your money and invest it wisely. According to a Boston Consulting Group Study in the asset management industry now manages over $100 trillion dollars.

Fund managers operate in a very wide range of disciplines, such as Global Equities, Asian Bonds, Australian Commodities, American Tech, Growth stocks, Cautious Investing and so on. Their primary claim is that they possess the skill and knowledge to "beat the market" over a given time period.

So what does "beating the market" actually mean? You hear in the news how the stock markets of the world performed on a certain day. On good news they tend to rise, on unexpected bad news they tend to fall. This performance is recorded according to an "index". For example in New Zealand the market index is the NZX 50, the fifty largest companies on the stock exchange. This is determined by the total value of their shares.

The most famous market indices are in New York: the S&P 500 (the 500 most valuable firms on the New York Stock Exchange) and the Dow Jones Index (which is calculated in a more esoteric manner and has thus faded in importance over the years).

Global averages are also calculated by the likes of MSCI with their Global Market Index, which weights companies and markets by their size thus giving significant bias to Western companies.

Fund managers claim that they can beat these indices both as they rise and as they fall. They will grow their fund by more than the relevant index in good times, and not fall as much in bad times.

The rise of passive investment management

Since the 1970s a alternative approach has grown in prominence: passive investing. A passive fund, such as an "Exchange Traded Fund" or ETF, simply sets out to mirror the performance of an index. 

The premise of passive investing is that the market index cannot be beaten in the long term and so there is no point paying a manager to make decisions. ETFs are therefore typically much cheaper than actively managed funds. These low fees in turn help reduce the difference between their performance and that of the market.

In five decades the growth of ETFs has been impressive. The three biggest providers (Blackrock Vanguard and State Street) now collectively manage over $15 trillion dollars. At current rates, the Big Three will control over a quarter of S&P 500 equity by 2028, up from one-fifth in 2018 (source: FT Article).

According to Boston Consulting Group (mentioned previously), the passive funds now accounts for $22 trillion dollars of investment, with traditional active managers accounting for $32 trillion (the remainder monies being invested in alternatives such as hedge funds and speciality funds)

Another area where ETFs can be useful, however, is when investing in new or niche themes, rather than geographies. For example Rare Earths production, Crypto currencies or the legal Marijuana industry. These are often areas where active managers see little value in launching a specific fund and where stock picking is either too complex and/or too risky for the individual investor. 

So is active management now a dated con trick?

Some would argue that it's the ETF premise that is the con. As it is only active management that moves the market. If all investments turned passive, how could true price discovery work? 

A shrinking stock market

For a variety of reasons, many of the worlds stock markets are contracting, in some cases dramatically so. According to a CFA study the number of firms listed in America halved between 1996 and 2016. 

Passive investing is restricted to listed firms. Active mangers are not. So the opportunities to participate in the growth of a company for passive investors, are rapidly reducing.

Also the active manager can profit from being invested in the firm prior to its IPO (see my blog on this for an explanation). In many cases it is at the point of IPO that the significant profit is made.

So this trend is arguably playing into the hands of active managers.

So which method works best?

Study after study shows that very few managers consistently beat their benchmark index for more than a few consecutive years. Personal finance experts such as Mary Holm (who writes in the New Zealand Herald each weekend) is a strong advocate of ETF investing. 

My personal view is that both approaches have their merits. For example, in my experience the further West the market, the greater the case for passive investment. I am unconvinced as to why anyone would pay an active manager when investing in America. The case for active investment in Europe is stronger but still by no means compelling (bar a couple of managers such as Terry Smith and Ballie Gifford).

It is when you reach Asia that I believe active management really comes into its own. The markets there are far less developed and rather opaque. Political risk is also generally greater here and there's certain areas you might not want too much exposure to.

For example the iShares MSCI EM Asia ETF holds over $1.6 billion dollars. As it is compiled by the size of the company, two major Chinese firms are the third and fifth largest holdings. Alibaba represents almost 6% and Tencent over 5% of the fund. By comparison a great active manager such as Matthews Asia  holds only 2.9% in Tencent and nothing at all in Alibaba. Both these firms were recently victims of President Xi's regulatory crack-down. Alibaba's share price has now fallen over 15% this year and Tencent's is down over 20%. Hence the Matthews fund has recorded a positive quarter while its index has fallen.

I am not suggesting that Matthews knew what Xi was going to do, but they were able to manage the risks by not holding too much of either firm. An ETF, by definition, has no such discretion. Incidentally the Matthews fund outperforms its index ("beats the market") by 4% per annum since its launch in 2006. Fifteen years of significantly beating the market certainly validates the role of active management in Asian equities, for this manager at least.

Conclusion:

In my opinion a portfolio should therefore have a mix of ETFs and managed funds. It is rare to find an active manager that consistently beats the market, but as we have seen it is by no means impossible. Similarly there are areas where paying for active management appears to be unnecessary.

It is interesting to speculate what the effect of the continuing rise in passive investing will herald. Will markets become increasingly tranquil, with movements only determined by the buying and selling of an ETF? 

What about Initial Public Offerings (IPOs, see my earlier blog on this topic), would the equity markets still be attractive when so much of the investment is tied up in the largest firms? 

Would active management actually become easier as more and more opportunities are missed by the passive investors?

For now, I shall continue to employ both strategies in my portfolios.

 

Dunotter disclosures

Disclaimer: This communication is purely meant as information for general interest. It is in no way to be taken as financial advice or relied upon in any way for investment decisions.