Background & History
There have increasingly been two distinct, opposing schools of thought around investment methodology over recent years:
- “Active” (the traditional approach over many decades) in which a fund manager picks stocks that they believe to have a better chance of performing well than other comparable stocks (e.g. buying a subset of 40 of the 500 stocks in the S&P 500 index to make up “Active Fund X”).
- “Passive” (the “upcoming challenger” approach) in which a fund manager simply replicates an index (e.g. by buying all 500 stocks in the S&P 500 index, or by replicating the 500 holdings synthetically, to create “Passive Fund Y”).
The passive investment approach, pioneered by the introduction of the first index-tracking fund by Vanguard in 1976, has grown rapidly in popularity, with the amount of money in passive US Equity funds actually overtaking the amount in active US Equity funds, in 2019. For more on passive investing via Exchange Traded Funds (ETFs), please see my article from 2017, here.
The Main Arguments for Passive
Some of the growth in popularity for passive funds can be attributed to their significantly lower fund-level costs compared with active funds (reflecting the rather simpler job that the passive fund manager is performing) e.g. 0.2% rather than 0.9% p.a. so, quite a considerable (and compounding) difference!
Another major factor contributing to the popularity of passive investing has been the indisputable fact that active funds rarely beat the returns of passive funds, on a consistent basis, particularly when their relatively higher fund-level costs are factored in (i.e. “net performance” is compared).
One very public demonstration of the victory of passive over active was the $1m bet that Warren Buffet proposed in 2006 whereby he challenged a hedge fund to try to beat the performance of an S&P 500 index fund over a 10-year period (from January 1st 2008 to December 31st 2017). This was a bet that Buffet won rather decisively, with the S&P 500 index fund returning an average of 7.1% annually and the hedge fund only 2.2%, after fees.
Besides that infamous example, annual statistics on the underperformance of actively-managed funds vs. the benchmarks they are attempting to beat are available on the SPIVA website maintained by S&P Global. At the time of writing, a rather damning 89.4% of actively-managed funds that have tried to beat the S&P 500 (by “actively” choosing a subset of its constituents) have underperformed the index over the last 15 years. The statistics for other regional indices are equally damning e.g. 82.9% in Australia, 86.2% in Japan, 87.8% in Europe etc.
The Main Arguments for Active
As per principle #3 which I outlined in my article here I do believe that it is worth fully considering both sides in any argument, particularly in this era in which “passive” seems to be increasingly winning that argument.
On the positive side for active funds, I would argue that there are indeed a select few situations where they may usefully still be considered:
- Where exposure to a niche sector, region or theme is only achievable via an active fund (i.e. there is no passive fund with the required exposure). With the proliferation of ETFs in recent years, this is rarely still the case, but may arise.
- Where exposure to a “Frontier Market” (one rung below an “Emerging Market”) is required, since there tends to be a tangible value in local knowledge in the absence of the “Efficient Markets Hypothesis” (the idea that stock prices reflect all available market information), due to the rather more opaque market information associated with such nascent markets.
Factors – a Better Approach than Active?
A factor is a set of criteria for automatically picking a subset of stocks, rather than employing an expensive (and probably Lamborghini-driving) human fund manager to do so. These criteria arose from the academic research and backtesting pioneered by Fama & French in the early 1990’s.
I like to use factor-based ETFs because this intuitively aligns with my suspicion that there “must” be a way of usefully picking a subset of stocks that can beat the benchmark to which they belong, whilst also not wanting to be dependent on an expensive, human fund manager to do so (who, alongside their expensiveness, will also suffer from all of the usual human behavioural flaws which make us all bad investors; primarily, ego-driven action and inaction).
“Horse Racing”
I like to use a real-world metaphor when it comes to exploring differing sides of a conceptual argument. For the “Active vs. Passive” debate, I would suggest the metaphor of a horse race as a symbolic equivalent to the stock market.
In horse-racing terms, I would propose that:
- passive investing is akin to betting on all of the horses in a race (in the belief that one will almost definitely win, and most will at least finish), whereas
- both factor and active investing involve excluding some of the horses (e.g. on the basis of them having fewer than four legs and/or overweight jockeys), however the betting slip is significantly more expensive for the “active investing” bet than the “factor investing” bet.
To me, it stands to reason that we should in theory be able to successfully apply criteria to choose a more specific selection of stocks than simply buying the whole index, and my preferred method of applying these is, decidedly, the factor-based approach.
Conclusion
I like passive funds for their instant diversification and low cost. Think of these as the “sponge” of the portfolio allocation “cake”.
To “scratch the itch” to outperform, I like proportionally smaller exposure to low-cost, factor-based ETFs, where the criteria make intuitive sense to me. Think of these as the proportionally smaller “icing” in the portfolio allocation “cake”.
In rare cases, I may deploy actively-managed funds, but only where truly warranted. These are the optional, and proportionally “fun-size” cherries on the portfolio allocation “cake”.
Where do I fall in the “Active vs. Passive” debate?
I’m happy to say, in conclusion: somewhere in the middle, but very largely towards the “Passive” end of the spectrum.
Michael Davidson is a Singapore-trained and qualified Financial Adviser with Global Financial Consultants Pte Ltd providing specialist financial advice and portfolio management services to international and local professionals in Singapore.
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*Please note that Michael Davidson is not a tax specialist or accountant and that none of the content outlined here should be taken as personal advice. You should consult your tax specialist and financial adviser to review your current financial situation and futures goals to consider whether this strategy is appropriate for you. I expressly disclaim all and any liability to any person or organisation, in respect of anything, and of the consequences of anything done or omitted to be done by any such person in reliance, whether whole or in part, upon the whole or any part of the contents of this article.
