Passive v active debate ignores theory v practice

John Kenchington

Passive investing evangelists appeared to bag another victory last week when an academic report claimed investors would be 1.44 per cent a year better off by switching to trackers.

Professor David Blake, the Pensions Institute director based at City University’s Cass Business School, published the paper. It must be considered within the context of an academic debate.

In 2006, US fund research by Kosowski et al found “overwhelming” evidence that some active managers have superior talent using a technique called ‘bootstrapping’. This refuted the prevailing consensus that active cannot beat an index and luck alone must be at play if it does.

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However, in 2010 US academics Fama and French refuted Kosowski’s findings with their own bootstrap that considered funds’ ‘Jensen alpha’ – essentially a way of risk-adjusting fund performance. They found there was no evidence of skill.

Cass’s paper last week compared the two bootstraps.

Cass came out broadly in support of the Fama and French research, saying that the vast majority of fund managers are “genuinely unskilled”. A small number of ‘star’ fund managers exists but they are too difficult to identify, it said.

In a press release it claimed a typical investor would therefore be 1.44 per cent better off by buying a passive tracker, given the futility of trying to find a star manager.

I took issue with this as, of course, passive funds have costs of their own and may also suffer tracking error, so this cost spread is likely to be less wide.

I pointed out the research was based on historic ‘dirty’ share classes for funds, therefore also reflecting the advice and platform fees that used to be collected by funds, in addition to their own fees. Mr Blake accepted both points.

All in all, the report is a sophisticated piece of work and further evidences the fact that many funds really are dross. But does that mean the whole active fund management idea is a massive sham? Probably not, because there’s a difference between theory and practice.

In practice, claiming ‘the average fund’ is a rip off would only be relevant if all investors owned all funds available all the time. But they don’t.

If you are bullish on the UK you buy Richard Buxton. If you think the world’s going to hell in a handcart, you call Martin Gray. Smart investors view these funds through the prism of their stylistic differences.

Passive funds, or even ‘smart beta’, could never reconstruct style because there are too many variables; it’s too subjective.

Those who want to do away with active completely are like the communists of financial services – they want everybody to live on the same basic handout.

But where’s the fun in that? I’d rather take my chances and back fund managers when I think their styles are coming into play.