Simon Evan Cook, manager of Premier multi-asset funds, respects the 'average investor' argument in the active v passive investment debate, but he argues it sidesteps a crucial factor...
We are ardent advocates of good active management; however, stating this case is to swim against the tide, as passive funds continue to grow in popularity. Now, having planted our flag with Canute-like stubbornness on the active side of the debate, we have heard most of the counterpoints to our own view.
A chief one is that, collectively, all investors are the market, so the average investor will receive the market return less charges paid. It makes sense to invest in the cheapest fund you can find: the tracker.
This argument is often put forward by commentators who are wrestling with weighty issues, such as a nation's pension provision. They are highlighting the simple truth that, if everyone in a country is banking on an annualised return of, say, 8% from their pension pot, but the stock market is only able to return 6% (before any management charges), a problematic shortfall is inevitable.
We have no problem with this argument. Its truth is undeniable and it demonstrates a very real problem that, at a national level, active management can only make it worse (because of its higher fees).
Our response is, while that may be true at a national level, it is not true for an individual.
Individual investors who are smart, disciplined and active can - and do - outperform the market over the long term. In doing so, they can generate the 8% return needed for their own pensions. However, by extension, they need other investors to make 4% to bring everything back into kilter.
Base rate (no, not that base rate)
We also find the same ‘average investor' argument is put forward by many individuals in respect of their own investments. Again, we do not take issue here; in fact, we respect it.
An individual picking a tracker shows a refreshing lack of arrogance. They have recognised what is known in behavioural finance as a ‘base rate': a start point upon which to base a rational decision. In this case, the base rate is the fact the average investor will underperform the market because of charges. A passive buyer admits there is no reason to believe he is better than average, so he should buy the cheaper tracker.
However, much as we admire the humility involved in this decision, it represents only the first step in becoming a better investor.
For having had the good sense to identify that base rate, it is logical to keep going. Why not seek more accurate base rates that further improve your chances of investment success?
To put this another way, actuaries estimating a specific person's life expectancy do not stop at the average age for a human but consider crucial factors such as gender and country of residence.
The point here is that a high level average, such as the life expectancy of a human or the return made by an investor, masks huge differences at the individual level. By seeking out reliable factors that refine the information further, actuaries and investors can improve their results.
Bolton and Buffett set examples
In the investment world, there are many such base rates that provide a better starting point for grounded investors. These are well set out in numerous research papers and have been proved in practice by investors such as Warren Buffett or Anthony Bolton.
One example is to be a genuinely active stockpicker (i.e. ignore the benchmark), while spreading your risks sensibly. This was highlighted in a paper by Antti Petajisto, who demonstrated quantitatively that mutual funds adhering to this discipline (as measured by two relatively simple factors) were the only type that consistently beat the market after charges.
In a similar vein, the Cass Business School made a monkey of using indices as a starting point. They demonstrated that even randomly selecting a portfolio of stocks performs better than mimicking a market-weighted index.
Another base rate that improves an investor's chances is to buy cheap stocks and avoid expensive ones - a.k.a. ‘value' investing. Since 1971, for example, the MSCI World Value index has returned 1.25% a year more than the MSCI World index (which compounds up to an outperformance of 3,429% in that time).
Why on Earth would a rational investor ignore a statistic like that?
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