Active and passive: the final verdict

As the UK’s summer of sport sprints to its conclusion, so does my series of columns about the Olympic tussle between active and passive managers of investment funds.

A number of weeks ago, I suggested that it was mathematically impossible for active managers of funds to argue that they could still, on average, meet or outperform their benchmark indices consistently in the long term. (Any cursory analysis of a broad range of IMA sectors confirms this point.) It is also deceptively difficult to pick outperforming managers based on their past performance – as Schroders’ head of manager selection Rob Hall demonstrates in his column on page 7.

The argument for active management has to be that passively managed funds do not necessarily guarantee investors can meet their goals – merely follow swings in the market. (Equity markets over the past 12 years have been a case in point.) If an active manager can do more to guarantee clients meet realistic goals, it matters little whether they underperform under certain market conditions – such as when a bull market exceeds a client’s wildest expectations. The problem is that managers worry too much about whether they will underperform in a bull market – a time when clients are happiest and they are least likely to lose them – and too little about preserving clients’ capital during difficult times. As Warren Buffett, the world’s richest investor, said about investing: “Rule number one is ‘never lose money’. Rule number two is ‘never forget rule number one.”

On that basis, then, the past five years have been a marvellous show-room for active managers of developed world equity funds – that is, those who have outperformed. An active manager emerging unscathed from this market is likely to be able to reassure clients of their ability to deliver returns in upwards markets – the easy part – and in markets under pressure – the hard part. Nor am I advocating all managers become low-beta managers – managers who lose less than the market when the market falls, or gain less than the market when the market rises. The skill lies in meeting clients’ typical goals when investing in equities –delivering above-inflation returns – even when returns from the market are positive but undershoot inflation.

When above-inflation returns are plentiful, such active managers should be under less pressure to outperform, in the name of preserving clients’ capital.

Such is the nature of the fund management industry at present that these debates get lost. Commentators talk about funds “skimming off huge fees for poor management”.