One of the ongoing discussions in investing is the rise of Passive investing as opposed to Active investing. The reason why this is so prominent at the moment is that the value of funds operating a Passive strategy is growing at a double digit rate, largely at the expense of Active investing, and that many well respected Active investors such as Warren Buffet have recommended Passive investing for most people.
I define Passive investing as an investing strategy that tracks a multi-weighted index or portfolio. (See also note 1)
Active investing is where the Investor or Manager makes specific investment choices with the goal of beating a benchmark,
Investing in a Passive strategy is essentially an investment on the index. You have agreed to take the index performance, (less management fees).
In an Active scenario you can beat the index, but can pay considerably higher management fees.
So from the get go Passive sets out to slightly underperform and in theory Active seeks outperform.
To illustrate the two types of investing I propose to use a theoretical market of 10 shares. At the start of this example each company has the same share value and we will allow that with the information available the shares are sensibly priced.
Company Share Price
A £10
B £10
C £10
D £10
E £10
F £10
G £10
H £10
I £10
J £10
Total Market Value £100
As the year goes on the market becomes aware that;
Company A & B will double its profits above expectation and this looks likely to continue.
Company C & D will make 50% more than expected and this looks likely to continue.
E,F, G, and H will all proceed as expected.
I and J will make ½ of expectations and this too is likely to continue.
As a rational investor you might expect the following share price profile after the news comes out;
Company Share Price
A £20
B £20
C £15
D £15
E £10
F £10
G £10
H £10
I £5
J £5
Total Mkt Value £120
But in a purely Passive market this does not happen. The index is bought at the start and under a Passive scheme there will be no changes in the index as there is no activity to prompt the index change.
Shares only move if people want more or less of them, but if you buy an index you are not buying individual shares but the index.
In a purely passive market price changes are driven not by the companies themselves but by inflows or outflows of capital into the market. So whilst we have Quantitive Easing we should expect that Passive investing will drive prices up. Once QE reduces we should expect prices to go down. Equally if there is a move into Emerging Markets the Passive Emerging Market vehicles should move up regardless of the performance of the individual constituents. It is not the performance of the actual constituents that moves the Market it is the flow of funds into or out of the market. A rising tide floats all boats, and the converse also applies.
Prices of individual companies are driven to outperform an index because investors actively seek them out to buy. Only an Active strategy would cause the price differentials I have created in the model based on individual company performance.
Why then is money flowing to Passive funds and away from Active funds;
- Passive funds are currently still able to ride on the Active industry. At the moment most markets are still well over 50% Active as such the Passive investor would have seen, in our example, the index rise to £120 and that £20 gain would have been achieved for a relatively low fee of 0.2-2%. In theory this free rider effect should be diminishing as the Passive % of the market grows but it is not known whether this would be a gradual decline or more of a cliff edge effect.
- Many Active funds are in fact Passive. They buy so many different shares that they become effectively a Passive fund for a higher cost.
- Many Active funds charge fees in excess of their outperformance. If they buy C, D, F, G, I in equal weight (£20 each) and only make £10, if they then charge £10 clearly the Passive fund wins.
- Nobody knows what will happen in the future. But faced with a known cost base of 0.2-2% (Passive) as opposed to 2-15% (Active) many people will focus on the known cost and go Passive. (Note 2)
- Some Active funds will underperform. Some Active investors will pick H,I,J in our market and fail to deliver results.
- Passive funds will hug the benchmark, year on year. An Active fund should be expected to have years both above and below the index. If it’s a good fund it will routinely outperform, But many investors don’t want to live with the poor years. Depending on who you listen too most people feel the downside between 2 and 6 times more than the upside. So the poor performing years are given a significantly higher rating than the outperforming years.
- Many Active funds set themselves up to fail. With managers who have to meet targets weekly or monthly they cannot afford to do what they know to be sensible over a longer horizon they have to meet their metrics today. I had lunch with one Investor who was reviewing a fund where the Investment Officer had to generate a monthly report to his Manager. This was also reviewed by the Fund Board each month and two external investment consultancies. In order to justify themselves the Manager, the Board and both consultancies were generating reports that had pretty routinely got to say something other than the Investment Officer was doing the right thing. So not only was the Investment Officer under constant criticism, but the actual fund investors were paying for a lot of people to overview the Investment Officer. Huge cost base, very short term view.
- Passive investing has good marketing and nowadays a big budget. I have written before that the most significant skill for a fund manager is his ability to sell a story that will attract funds. Passive investing has the great story of price. It is relatively cheap and it has the reality that many Active funds underperform. It also has some big players like Vanguard who are spending a lot of money on advertising the Passive case.
- Because they can pick Companies H, I, J the worst performing funds will almost always be Active. Conversely a Passive fund in which you have accepted slight underperformance should never dramatically underperform. So if you average Active funds the failures will drag down the successes.
- Active funds can be easy to reject. Many use unsuitable or generally underperforming index’s to benchmark or change the benchmark as a way to hide underperformance. A little work spots this but tars the other Active funds.
But ultimately a Passive fund will never outperform as this is not its intention. Only an Active fund can outperform so I would suggest that for most people the sensible approach is to spend their effort in identifying those Active funds that genuinely have the capability to outperform and investing with these. But assessing the capability to outperform means taking all the factors, including cost, investment style and history into account. This is not easy but can be worth the effort.
If you cannot make this assessment then a Passive strategy makes sense. I for one cannot make an assessment of the funds investing in Russia so if I was to invest here I would opt for a Passive fund. But this would in effect be based on a Macro view as to Russia being as an index undervalued.
So for me it’s Active where you can do the work and have a sensible opinion on the fund and Passive where you don’t. (Note 3)
Note 1
Without going in to too much detail readers should be aware that Passive investing can in fact involve a number of complications, such as leverage, buying synthetics to replicate (hopefully) the stated portfolio and of course many variations on portolio tracking. For instance is the replication based on holding the same number of each share of the index constituents, the same value of the index constituents, or some variety of market capitalisation related holding. As such even when investing in a Passive strategy the investor should be careful to understand the underlying assets that are being bought and the basis for the fund to decide on what to buy.
Note 2
There is a wide range of charges inherent in any fund. Stated charge rates can be much closer in actuality than they at first seem. A fund that charges 0.2% portfolio management fee, but has within it a 2% expense ratio, is of course not better than a fund that charges 1.5% portfolio management but has only a 0.5% expense management ratio. I have only seen a 15% fee once, on a fund of funds. It was a lot cheaper to read the monthly report and buy the core funds directly. Particularly as none of the core funds changed over a 2 year period.
Note 3
Perhaps the most famous exponent of Passive investing is Vanguard, under its founder Jack Bogle. Yet within Vanguard there is a wide range of Active funds. These exist in part because Vanguard wants your money however they can get it, (more Assets Under Management, AUM, more fees), but also because Vanguard knows that Active funds can provide outperformance.