Head-to-head: active vs. passive

The DC Investment Forum, a group of active asset managers, claim the use of passive investment management techniques could damage the interests of savers. Here, two industry commentators, (Andy Dickson, Investment Director, UK Business Development, Standard Life Investments and Mark Taylor, Director of Investment Services at Equiniti) with strong, but opposed, views debate whether active or passive management offers savers better value for money.

 

THE QUESTIONS

1) Are higher charges for actively managed funds a lesser evil than a passive fund being obliged to own an index’s worst- performing stocks and being biased towards the most over-valued shares?

Dickson: Active asset managers argue that passive management is an inefficient use of capital, because it:

• buys more of an asset as it becomes more overvalued;

• is economically pro-cyclical, resulting in overexposure to inflated trends and increased volatility.

Some scheme trustees, alarmed by faltering short-term performance, have resorted to passive management, at least for their default funds. Their focus on value for money is understandable. But it leaves investment risks completely unmanaged – at a time when markets are constantly changing. We believe that asset allocation needs to be a dynamic process, particularly as it’s the largest single determinant of risk and return.

DB schemes typically employ a range of investment strategies to manage the uncertainty inherent in traditional asset classes such as equities and bonds. As liabilities or pension benefits are increasingly driving the management of DB investment strategies, why should it be any different for DC? DC savers need a retirement income as do DB members, but they arguably have even less tolerance to risk, since they stand alone in terms of meeting their long-term needs.

Given the more material importance of return and risk to the level and predictability of outcome – especially when adopting a much greater degree of diversification – cost is increasingly being seen as a lesser evil.

Taylor: The answer to this question lies with the investor’s appetite for risk. Many investors believe, rightly or wrongly, that index investing is low risk. This could not be further from the truth. If we take the FTSE 100 index, the most widely referenced index used by the media, three sectors alone account for nearly half of the index by market weighting.

Source: ShareScope

In addition, the FTSE 100 has become a global index as many of the stocks within the index derive a major part of their earnings from overseas. Indeed, two of the latest stocks to be admitted to the FTSE are Russian companies, Steelmaker Evraz and Polymetal International a gold and silver producer.

This means that investors are potentially taking higher risks as the fund is not sufficiently diversified across sectors to spread the risk.

The composition of the FTSE index is changing and no longer represents a true picture of the UK marketplace. A better representation would be the FTSE All-Share Index, which is much more broadly based.

By definition, an index tracking fund has to replicate or mimic the underlying stocks of the benchmark index. Investors will hold both underperforming stocks and outperforming stocks but they will have the comfort that the fund will be performing as well as the index but without excessive fees.

Because index funds have become commoditised and are compared upon charges and tracking error they have become increasingly efficient in recent years, with large funds in well-established indices being managed for less than 10 basis points. The same can hardly be said for most active fund managers who still work on the basis of higher fees for potential outperformance irrespective of returns.

What this illustrates is the fact that an index fund almost becomes a self-fulfilling prophecy over time. Weaker performing companies will fall-out of the index and be replaced by stronger performers. Trustees need to be comfortable with their asset allocations to index funds and be confident that they understand the underlying composition of an index.

 

2) Should trustees view with scepticism active managers’ claims to outperform given their noticeable failure to sidestep the worst of the equity markets in 2008, or should trustees consider that active investors tend to do well when there is a big difference between the returns of the best-performing and the worst-performing stocks?

Taylor: The performance statistics speak for themselves. Research conducted by Citywire in late 2011 showed that around 33% of active fund managers added value. This meant that two out of every three fund managers failed to beat their relative index. When markets fail to trade on fundamentals, such as company earnings or a firm’s pricing power, it becomes increasingly difficult for fund managers to select stock. Many resort to quasi-tracking of their relative index placing bets by overweighting stocks or sectors that they believe will have an inverse correlation to the benchmark. The economic and often volatile market conditions of the last few years have made it extremely difficult for fund managers to outperform indices without taking higher degrees of risk. Fund managers often promote their ability to outperform the market but despite moves by the regulators, are selective around the periods they choose to illustrate their track records.

Dickson: The majority of investment mandates do not allow managers the opportunity to sidestep the kind of market falls seen in 2008. Managers are tasked mainly with outperforming a market index without deviating too wildly from it. This means that even materially outperforming a falling benchmark could result in a loss in value – and the investor is unlikely to be happy.

DC plan managers have been looking for a better solution – and several now provide alternative approaches designed to eliminate this outcome. Absolute-return and target-return funds (which aim to deliver a positive return over the longer term without adherence to a traditional benchmark) are gaining popularity with trustees, especially during these volatile times. This approach is particularly relevant for DC scheme members, who unlike DB members assume the whole burden of investment risk.

 

3) Should the primary concern of trustees be to concentrate on minimising costs or risk minimisation?

Dickson: DC trustees should maximise the likelihood of a good financial outcome for their members. Costs are one element of this – but it is far more important to reduce risk by taking sensibly managed positions. However, eliminating investment risk is not a zero-risk proposition. Using cash deposits as the investment vehicle, for instance, would remove volatility – but it would also produce little growth. We would advise reducing risk by focusing on the asset allocation rather than active v passive issues. We believe that absolute-return and diversified-growth funds can reduce volatility and diversify return sources. This can deliver an outcome that has both return potential and a reduction of overall investment risk, at reasonable cost.

Taylor: Both. Not all index funds perform the same, expense ratios, fees and tracking error can drastically impact an index fund’s performance. Therefore, if trustees decide to invest in index funds they need to ensure that a) the index fund is being run efficiently and b) the fund has the smallest amount of tracking error possible. This tends to be easier for larger funds operating in the better known indices.

However, the risk of index tracking funds significantly increases if a trustee chooses to invest in a sector index. Some sector indices can be made-up from as little as 30 stocks, this can mean that the fund is narrowly focussed and can therefore expose the investor to greater risk. Therefore, the trustee needs to be comfortable with the overall asset allocation of a portfolio to ensure that an investment in a sector index fund is not exposing the overall portfolio to a higher degree of risk despite lower costs.

 

4) Is passive management best suited to efficient, developed markets, where active managers struggle to unearth undiscovered investment opportunities?

Taylor: In the majority of cases the answer is going to be yes, for all of the reasons above. Smaller developing markets present difficulties for passive managers due to liquidity and shortage of stock, meaning that it can be difficult to fully replicate an index, leading to a higher tracking error. This can be alleviated by the use of synthetic instruments but in less well developed markets this can still prove to be problematic.

Dickson: Passive management is clearly the correct approach if there is a lack of bottom up investment insight and this will be hard and expensive to generate in developed equity markets. However, we do not accept that even these markets are efficient and in a market such as credit active managers can add value and avoid exposure to defaults or overexposure to counterparty risk. Overall, market exposure still needs active management to produce a more reliable outcome.