In the first of a new regular series for Professional Adviser reviewing the hot topics that have been keeping him busy over the past month, John Husselbee considers issues thrown up by the so-called active/passive 'debate'
The choice between active and passive styles of investing remains a divisive issue in financial circles but, for me, the more important point is that the growing focus on this subject could potentially be leading investors into some serious mistakes.
I enjoy reading many of the financial publications that cross my desk and working on a client presentation after the Christmas break led to me to recall several points outlined in a book that distracted me from turkey and mince pies over the recent holiday period.
Written by several senior money managers from US firm Epoch Investment Partners, the book is called Winning at Active Management and is well worth looking up. As the book's subheading explicitly acknowledges Epoch sees three key factors to successful active management - namely culture, philosophy and technology - but the authors also have plenty to say on the question of active versus passive investing.
As a part of their argument, a chapter is devoted to summarising the so-called ‘great debate' that took place in New York in 2015 between stockpicker - and flag-waver for active management - Jim Grant and passive advocate and Vanguard Group founder John Bogle.
In brief, Bogle claimed active investing is effectively a zero sum game with the average manager underperforming when fees are taken into account. Unsurprisingly, Grant dismissed the view that cost is enough to determine performance over the long term and said plenty of active managers have proved able to beat the market.
The authors conclude that most observers said the debate ended up an honourable draw but one area where the two did broadly agree is that for fund buyers with neither the time nor the tools to peruse the market, an index tracker is likely to prove the better option.
I agree with that for the most part but would add a couple of points. The first is to consider the equity market in question - the US market is considered the most efficient in the world and studies perennially show active managers struggling to outperform it over the long term.
As the US is the largest and most influential global market, it is often used as a proxy for equities in the rest of the world. But a simple performance analysis over the last 10 years shows a higher proportion of active managers beating the index in the UK, Europe, Japan, Asia Pacific and emerging markets so it is important to bear that in mind when reading these - usually US-centred - reports.
Second - and more important - is the fact that, for professional investors with the time and skill to filter the market, I do believe it is possible to develop a process to identify successful active managers - as long as you are patient.
Consistency of process
No manager can produce market-beating returns every year but, while I do not believe consistency of performance is possible, consistency of process very much is and duly forms a key part of our fund selection process.
Our estimates show the best active managers will - on average - beat the market in six out of every 10 years. Interestingly, that kind of ratio also applies to the most successful operators in the world of sports.
This column is not supposed to be a defence of active management - indeed, our own approach is to blend active and passive in an overall target risk portfolio. Our starting point is passive - when investing in an asset class, we will identify the availability and suitability of tracker options first and then look at whether it is worth paying up for adding in active managers. In areas such as smaller companies or high yield, for example, it is difficult to find passive exposure.
Looking past these issues, I also believe focusing too much on active versus passive and saving a few basis points in costs can see investors falling into potentially much more damaging decisions.
Take another key part of implementing a successful long-term investment process: ‘buy low, sell high'. Any study of behavioural finance will seek to tell you investors tend to do the opposite. Looking at the Investment Association's monthly sales figures shows investors often piling into sectors right at the very top of the market before significant slumps and also panicking at the bottom of the market and selling assets just before they rally.
Compounding this error - and coming back to the active/passive question - many investors also put money into active funds as their investment style is peaking. Funds that have enjoyed a strong run often take in considerable assets just before their style tops out, leading to disappointed investors if performance goes through a fallow period.
Again, this is where patience is absolutely key to successful investing - and the active/passive debate should never obscure that.
John Husselbee is head of multi-asset at Liontrust
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With effect from 3 January 2018
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