The active versus passive debate has been powerfully reignited by the FCA’s interim report of its asset management market study.
As with previous iterations of this debate, the current discussion is focused on the dimensions of aggregate performance and cost. While the importance of these issues should not be underestimated, they are merely the most visible symptoms of the main challenge faced by investors, namely that finding good investments is incredibly difficult, and that we often fail to fully exploit those that we do find due to our lack of patience and desire for novelty.
This is equally true at both the security selection and manager selection levels. Driven by short-term performance considerations, fund managers seldom put enough capital in their best ideas or hold these positions for long enough for them to meaningfully add to returns. This challenge was highlighted by professor Martijn Cremers in his paper on ‘Patient Capital Outperformance’. It notes: “Among high active share portfolios, only funds with patient investment strategies on average outperform by more than two per cent a year. Funds trading frequently generally underperform, including those with high active share.” This suggests that fund managers are too quick to dismiss the good ideas of yesterday in favour of new ideas today.
This recency bias is equally true of fund selectors, who often place too much emphasis on the recent past performance of a manager as an indicator of the quality of the investment process. Consequently, investors tend to buy and sell at the wrong times. The impact of this can be seen in research comparing funds’ time-weighted and money-weighted returns. While the former represents the numbers used in performance tables, the latter is the experience of the average investor in that fund. We call this difference in returns the ‘behaviour gap’, as it reflects the impact of counterproductive trading behaviour by investors.
It is well known that few active managers can beat their benchmarks by a meaningful amount over long periods of time, and our experience is that those who do are unable to do so consistently. This is because differentiated performance necessitates a differentiated portfolio, which will experience periods of significant underperformance. Therefore, by chasing the consistency of short-term returns, investors tend to sacrifice the potential for substantial outperformance.
Fortunately, there are a few ways that this unhelpful bias for activity and novelty can be addressed, and the first is to commit to long holding periods. This commitment was best articulated by veteran investor Warren Buffett, who wrote “our favourite holding period is forever”. As it is difficult to do this in practice, we advocate slowing down the investment process to encourage research and inactivity. This can be done be creating a culture of strong peer review and high barriers to portfolio turnover.
We also need to be honest about the paucity of good investment opportunities and incorporate the reality of this scarcity in the way we manage investors’ capital. As investors, we are likely to identify very few great ideas at either the security, asset class or fund level, and therefore it is a mistake to squander these ideas in a vain attempt to forecast near-term returns. This long-term mindset is likely to mean that portfolios undergo periods of underperformance, but we need to explain to investors that this is a price worth paying to help them reach their long-term investment goals.
Dan Kemp is chief investment officer at Morningstar Investment Management
