“The index fund is a most unlikely hero for the typical investor. It is no more (nor less) than a broadly diversified portfolio, typically run at rock-bottom costs, without the putative benefit of a brilliant, resourceful, and highly skilled portfolio manager. The index fund simply buys and holds the securities in a particular index, in proportion to their weight in the index. The concept is simplicity writ large.”
― John C. Bogle
The argument goes something like this. Investing in a passive fund 80% of the time will outperform an active fund and save you about 0.5% per annum in charges. The 0.5% when added in was what makes the difference. A study in the US in 2016, showed 90% of active managers failed to beat the S&P 500 Index over 1, 5 and 10 years which further supports this argument.
When we started managing client money, we were very much in the active camp. Our view was that a good fund manager will always outperform over the long term.
In this blog we want to explore the passive vs active argument.
What does a good active manager look like?
Some managers we meet are initially apologetic because they are managing assets of £20 or £50 million. They will often go on to assure us that they want to grow the fund but there is a chicken and egg situation. Many fund selectors will not even look at a fund that has under £100 million in assets. So, good fund, but can’t grow the assets due to current size. (Catch 22!)
We think size does matter when it comes to investing. Three funds spring to mind where asset values spiralled and performance dropped away – M&G Optimal Income Fund, Invesco Income Fund (then Woodford Income Fund) and SLI Global Absolute Return Strategies Fund.
A lot of the good performance we have seen has come from smaller funds. When we see performance dip, we can sometimes see the correlation with size. More often now, we meet managers who state that once the fund grows to ‘x’ they will ‘soft close’. This means that they will not actively take in new money to ensure that performance for existing investors is protected.
This seems strange in an industry that rewards on size, but we want those companies that are brave enough to say when they will soft close a fund. The other aspect is how aligned the fund manager is to the investors. We invest our money in the portfolios we manage. We go through the good and bad just like our clients. We feel that a manager should invest their money in the fund they manage; if he doesn’t invest in it, then why should we?
We are agnostic in terms of the size of the firm, but we do like small boutiques. The flow of information is often easier with direct access to managers. As a firm gets bigger you have less access and the value of assets we are looking to invest doesn’t always grant us direct access to managers.
None of this guarantees exceptional performance but it can provide a good guide.
Why is passive so popular
In previous blogs we have highlighted the importance of research. Using an active manager means you are placing a great deal of trust in that person. Managers are excellent at selling what they do. We try to look at why we shouldn’t invest in a fund and understand when it might underperform. Ultimately, we want to choose a fund that will work well in our portfolios.
In a similar way to us they can get it wrong and under perform. Or, they can paint a really good story, but the reality is somewhat different. The problem is compounded because you are paying higher fees for active management.
With the passive route you take away the need to research which manager is best because your goal is simply to match the performance of the index you are investing in. Passive managers simply buy all the stocks in a given market index, in the proportion they are held in that index.
Investors can quickly build up a portfolio of perhaps five or six passive funds and they know they will just replicate the index they hold.
Passive managers are passionate that theirs is the only way because charges are lower and poor performing active managers means in the long run they will outperform.
These arguments make passive investing attractive, especially when active managers like Woodford strengthen the argument. If you trust someone and they do what Woodford did then it seems like a no brainer.
A counter argument to passive is the human emotion of greed. Many people got caught up by the dot com bubble in the early 2000s. Most people are happy with their current returns until their neighbour pipes up with theirs and they want a slice of that pie.
Investors followed Woodford because of what he had done over the last 25 years, if they compared his recent performance, they would have seen this to be really poor. Bias can cloud judgement. We can be disappointed with just getting a return which is the same as the index.
What is the right approach?
We have taken a different view to when we first started. We now believe there is a place for passive and active. To explain, in the case of the US we agree it is hard to beat the index, so we think having a passive alongside an active fund is the right way to position the portfolios. We are looking for perhaps one exceptional fund who has demonstrated the ability to outperform, where the passive fund provides a cushion and the active provides an element of outperformance.
This is known as blending and is a useful strategy. For lower risk portfolios it can be better to have greater exposure to passive strategies to protect on the downside. As you go up the risk scale this reduces.
There is no right or wrong approach. It comes down to the ability to research and the time that someone has. If they have limited time and are happy to get the performance of the index, then passive could be the right route for them. If they can do the research then active might be the better option, and of course blending gives the best of both worlds.
Passive or not, that is the question
I get the arguments for using passive, but I think they are simplistic. It can save you ‘x’ per year and this could translate into ‘x’ out performance. Brilliant marketing, but it doesn’t reflect that there are good managers who outperform, and human emotions which want more than the index.
Over time you get a feel for what a good manager looks like, and how they behave. You will not always get it right, but experience and time will play a big part. When you bring this into the equation, the answer is not black or white. For us we see shades of grey.
Note: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.