In 2007, investment processes were less defined, Margot Robbie had yet to explain what a sub-prime mortgage was, and passive funds were only used by investors who were not capable of picking a talented fund manager.
It was against this backdrop that we started to adopt passives as the main building blocks for our range of risk graded model portfolios. Back then, the whole active versus passive debate produced views that were perhaps more polarised than they are today.
Ask what is the biggest advantage of using passives and the most common answer is that of the cost savings. A typical equity tracking fund has a total expense ratio (TER) of around 15bps, with dealing costs contributing an additional 5bps. The average cost of an actively managed equity fund comes in somewhat higher with TERs at around 75bps, with dealing costs adding on average an additional 140bps.
Any IFA who sets out to pick active funds which consistently generate alpha will know that this is a difficult and therefore expensive task. That is not to say it is impossible, it is just that there are around 195 (bps) reasons why the passive route might give better returns.
Even for me – an advocate of passive investment vehicles such as ETFs and index tracking funds – it stands to reason that from time to time it should be entirely possible to actively allocate more funds to asset classes that stand to benefit from the prevailing economic conditions and less to those that may suffer. This being the case, then tactical management of asset classes should deliver better results than a purely passive strategy where assets are rebalanced back to long run strategic positions.
However, if the underlying funds are actively managed – by a “star” fund manager who has set out his stall as a stock-picker – then how can you be sure that your tactical asset allocation call is being implemented accurately?
What if your star manager decides he does not like the look of the market and stockpiles cash? All of a sudden your asset allocation has markedly changed. You may have backed the right horse, but you have got the wrong jockey in the saddle.
So, how have passive funds performed over the last 10 years?
In the developed equity markets, we have witnessed significant underperformance of active funds versus passive.
Since May 2007, Legal and General’s UK Index Trust has grown 72 per cent, whereas the UT UK All Companies sector is up 66 per cent. Undoubtedly, a major driver of this underperformance is cost. The majority of these underperforming active funds are “closet trackers”, which are unwilling or unable to stray too far from their benchmark index. These funds offer none of the advantages of a skilled stock picking fund, nor any of the cost savings of a passive fund.
With hindsight, we could have produced better results by choosing a top performing active manager. The trouble is, we cannot choose funds with the benefit of hindsight. We are not aware whether this year’s top performing fund will be among the best performers in the future. We are however, reasonably confident that passive funds will produce better than market average returns over a five to 10-year period.
Perhaps more of a concern than absolute fund performance is the variance in volatility of active funds. Looking once again at the UK market, over the past 10 years, it would have been easy to unwittingly pick a fund which was up to 20 per cent more volatile than the L&G UK Index Trust. When thinking about robust portfolio construction techniques, is this the sort of risk we should be taking with our clients' portfolios?
Probably not
One response to my comments above may be to say that it is no surprise to see passive funds outperforming in the UK equity sector. Perceived wisdom may say that this is not an unexpected result, since it is difficult to outperform in mature, highly liquid markets. Perhaps we should just take a moment to see whether active funds fair better in, say, the emerging markets sector? Surely an active manager should be able to add value in a less efficient market place such as this? While this is indeed possible it is a relatively unlikely outcome. The average emerging market equity fund grew 82 per cent in the last decade, while the MSCI Emerging Markets index grew 97 per cent.
In each of the main equity sectors, we are able to access passive funds which produce performance that is very close to that of the index, and outperform the sector average. It is also striking to observe just how wide the variance of volatility is across the funds available. One should bear this in mind when choosing an active fund to populate a portfolio with a pre determined risk level.
Surely a more effective way to do this is to conservatively manage a portfolio of passive funds where you know that your asset allocation will be as accurate as possible with no risk of drift. While the major benefit of such a strategy is the perfect replication of the desired asset allocation, there is of course the welcome by-product of low cost and therefore higher than market average returns.
This is borne out by the performance we have generated through a range of risk-graded model portfolios. At each level of risk, we have been able to generate superior returns, with less volatility than the respective RTMA (Risk Targeted Multi Asset) sector average performance levels.
In my experience, investment solutions populated by active funds often produce less predictable and less consistent fund performance than their passive alternatives. Just because funds can frequently trade to react to prevailing market conditions, it does not mean that they should.
It is not easy for an actively managed fund to consistently outperform the market as a whole, but the increased levels of fees (relative to a passively managed fund) will definitely create a significant drag on the fund’s performance. It is important to always keep an eye on the big picture and remember that we are investors, not speculators. As unfashionable as it may sound, the most consistent method for delivering steady, risk-controlled returns is to choose a low cost, diverse long term strategy and then stick to it.
Philip Bailey is a partner with Assetfirst, a provider of passive investment solutions to the wealth management and IFA markets
Key Points
The biggest advantage of using passives is cost.
In the developed equity markets, there has been a significant underperformance of active funds verses passive.
Perhaps more of a concern than absolute fund performance is the variance in volatility of active funds.
