Passive v active

jamesd

The Vanguard PDF has the same sort of flaws as all of the studies I've seen. The bit you quoted has the most obvious one: it uses the average performance of active funds, while investors with free choice of funds do not have to pick average funds. Some funds have little money in them because they are dogs. Some have captive customer audience because they are say default funds in pension products or one of a limited number of choices. Another big one is that they completely ignore manager changes that are well known to be the cause of a change in fund performance that is normally a reason to sell a fund.

A buyer of a fund is not required to buy funds that are known poor performers. Not even if that known poor performance is due to a higher TER than the fund from the provider next door. Underperformance has been shown to persist and that's so for both active and passive funds.

The manager of an active fund is not required to buy or sell shares just because they enter or leave an index. Nor representative holdings of shares in a country like Korea because a tracker company changes the index it uses and the index provider decides that a country is or is not an emerging or developed market.

What were the investment performance reasons for these tracker asset allocation decisions?

1. Developed market trackers using MSCI indexes won't include Korea or Taiwan because MSCI says they are emerging markets. But if using the FTSE index Korea recently changed to included so investors would have seen an asset allocation change to include it.
2. Developed market trackers using MSCI indexes suddenly found that they had to have an Israel holding when MSCI added Israel to its developed market list in 2009. And the emerging markets funds had to sell because it was no longer emerging.
3. Cyprus is developed according to FTSE but not according to MSCI. But don't be sad, in MSCI you get Iceland while in FTSE you don't.
4. Greece is developed according to FTSE but not according to MSCI. Use an MSCI index and from June 2013 you found the "passive" developed market tracker fund selling Greece, at the timing announced by them then.
5. Prefer emerging markets? At the same time MSCI changed Qatar and UAE from Frontier to Emerging. And moved Morocco out of Emerging to Frontier.

I don't know about anyone else's opinion but I have some preference for my asset allocation and buy/sell decisions being made for reasons other than the index provider saying that in their opinion a country is or is not an emerging or developed market.

atypical

jamesd wrote: »

The Vanguard PDF has the same sort of flaws as all of the studies I've seen. The bit you quoted has the most obvious one: it uses the average performance of active funds, while investors with free choice of funds do not have to pick average funds. Some funds have little money in them because they are dogs. Some have captive customer audience because they are say default funds in pension products or one of a limited number of choices. Another big one is that they completely ignore manager changes that are well known to be the cause of a change in fund performance that is normally a reason to sell a fund.

A buyer of a fund is not required to buy funds that are known poor performers. Not even if that known poor performance is due to a higher TER than the fund from the provider next door. Underperformance has been shown to persist and that's so for both active and passive funds.

This issue is addressed from page 8 (and in the summary above). Picking future winners is the problem, which is why it's better not to try.

"The results appear to be slightly worse than random. While around 12.8% of the top funds remained in the top 20% of all funds over the subsequent five year period, an investor selecting a fund from the top 20% of all funds in 2008 stood a 65.4% chance of falling into the bottom 40% of all funds or seeing their fund disappear along the way. Indeed, we find that the percentage of highest quintile active funds falling to the lowest quintile or closing (48.1%) far exceeds the probability that they remain in the top quintile (12.8%). Stated another way, only 2.6% of the 1,684 funds achieved top quintile excess returns over both the five-years ended 2008 and the five years ended 2013."

masonic

The issue I've always had with research like the above is that they are taking a whole bunch of managed funds from different sectors and ranking them against each other. If you sort a diverse set of funds like this by performance, what you tend to see is that the top spots are dominated by funds from a specific sector, often a very adventurous sector that is doing extremely well that year, so one year it might be UK smaller companies, another year emerging markets and the next Commodities. The conclusion is therefore drawn that since these funds don't continue to outperform their rivals in other sectors, they make the case for passive investing.

However, if you were to do the same with the universe of passive funds, you would also see the FTSE250 tracker fluctuating against the Emerging markets tracker and these might go from being top performers one year to the bottom of the table the next year. So how can such comparisons be meaningful?

dunstonh

One has to remember that the Vanguard research, like so many, is based on the US market. In the US, funds have to pay tax on realised gains. That is not the case in the UK. Trackers have less realised gains than managed funds. Tax costs averaged 94 vs. 51 basis points annualised for active v passive funds, respectively, during the 15 years. This is known as the tax drag in the US.

Here is a pretty good article to read. It wont change anyone's mind but it shows that there is more to it and that no-one should sit 100% in either camp but aim to use the best of both.
https://www.fidelity.co.uk/investor/markets-insights/fund-news/details.page?whereParameter=fundnews/active-funds-trounce-passive

dale_cotterill

Given the nature of tracker funds and the fact that the buy every (or most) of the stocks on the index, and the fact they have consistently seen such large inflows over recent years. We must start reaching a point where there are a fair number of companies who are vastly over-valued based on their shares just been bought up by default, at the lower end of the market at least.

jamesd

atypical wrote: »

This issue is addressed from page 8 (and in the summary above). Picking future winners is the problem, which is why it's better not to try.

The problem is, the text you quoted did not address it properly, for the reasons I gave in my post.

Back in 2005 or so I looked at past performance of the global growth sector and watched what happened in subsequent years. The top ten funds remained at least in the top quartile for several years unless the manager changed. Yet they completely ignore changes of manager, while users of active funds know it's key information that must be considered.

Underperformance tends to persist. You don't need to pick winners to do better than average. Avoiding the persistent underperformers will be enough. Vanguard may pretend that I'm willing to buy a fund that has consistently underperformed but I'm not about to do that.

However, don't conclude from this that I do not use passive funds. I have a lot of money invested in Vanguard's global developed market tracker as well as in active managed funds. I think it's useful for the big companies in the bigger developed markets that it tends to hold. I am concerned about its high holdings in markets that are at quite high valuations and may start to hold some leveraged short ETFs or options to mitigate that risk.

Money-Saving-King

Surreyboy wrote: »

I think it's true that many or most active managers do fail to outperform the market over long periods

The thing that nags me with this is how much easier it is to get information now. If you're going to talk long periods then that will include when there was no Internet. Has anyone done a study since widespread information/the internet has been about?

All the studies I've read go so long term they include pre Internet days which could make a difference to how actively managed funds perform in the long term.

dunstonh wrote: »

One has to remember that the Vanguard research, like so many, is based on the US market. In the US, funds have to pay tax on realised gains. That is not the case in the UK. Trackers have less realised gains than managed funds. Tax costs averaged 94 vs. 51 basis points annualised for active v passive funds, respectively, during the 15 years. This is known as the tax drag in the US.

Here is a pretty good article to read. It wont change anyone's mind but it shows that there is more to it and that no-one should sit 100% in either camp but aim to use the best of both.
https://www.fidelity.co.uk/investor/markets-insights/fund-news/details.page?whereParameter=fundnews/active-funds-trounce-passive

This confirms my thoughts. Data analysis and the rate at which you can get information via the Internet have had a major effect on how well actively managed funds perform compared to trackers.

bowlhead99

dale_cotterill wrote: »

We must start reaching a point where there are a fair number of companies who are vastly over-valued based on their shares just been bought up by default, at the lower end of the market at least.

Logically that would also be true at the larger end of the market as well.

Say for example one of the major companies by market cap in a particular market is a very large business, and its physical scale in terms of assets or turnover and profits means that it could be valued at $100bn if it were on a sound footing. But nearly all analysts and brokers who have properly been able to look at the financials and the news reports about it and do some proprietary research, don't like what they see. Perhaps it's facing structural issues in the industry, its patents are expiring with no new money going into R&D, the board and the major shareholders are a bunch of idiots, all the technology needs replacing and the profits are on a downward trend without any expectation of reversal any time soon.

But it is a large company so despite the fact that good active managers are all avoiding it like the plague, trackers have to buy it. The price would only be $40bn based on what quality institutional investors or smart fund managers would pay for its prospects. But trackers with billions to deploy in the market are throwing billions into it, because they have to. So the price is $50bn. And if you buy a tracker you are putting 1000x as much capital into this ropey company that might be heading to the wall, as you are into the $50m company down the road.

Sure, there is an 'efficient markets hypothesis'. But it doesn't always work 100% of the time. Particularly if this company is in a less developed market, an 'emerging' one, where information flow is imperfect and corporate governance issues abound, there can be a great disconnect between a company's valuation and its price from time to time. People haven't yet come in and shorted it down to the 'fair' level because they don't have the information. Smart people stopped buying, but dumb tracking machines kept buying. And the valuation hasn't fallen enough yet for the price to be fair.

And some mediocre or downright bad active fund managers, who don't have a decent team of local analysts - but are facing a wall of money to be invested in this geographical area while investors throw cash at 'high growth potential' regions - will have no issue chucking money into buying shares of this large company at valuation levels that it does not at all deserve on fundamentals. Because hey, if it's a big company and you buy it, you will get a result close to the 'benchmark' index even if that result is a stinker. And investors will keep paying you your fees because they are not doing their proper research on your track record because they are just desperate to get their money into China or Thailand or wherever. Those particular active managers are not the ones you should seek out, and they are not the ones you would find yourself selecting based on long term performance, but they drag down the 'average return of an active fund manager'.

So in some markets, trackers can be significantly outperformed by good active managers, consistently over time. The active managers will try to avoid the dogs, with the result that they relatively overweight the non-dogs even if they don't find all the superstars that they would be looking for. This can give you a nice result if you have reviewed a manager's track record in the sector before you take the plunge, because such results, driven not by randomness but by a quality management team and sensible strategy, can persist over time despite the tracker firms telling you they won't.

Of course, the trackers buy up all the dogs and all the superstars too, but a potential issue is that the superstars of the future are often not in the top quartile of a market-cap weighted index at the time you are looking to buy in, while the dogs may well be.

I would agree with others that it is harder to consistently outperform in a major developed market like US largecap, than it is in niche specialist less mainstream sectors like emerging markets, small companies etc, and I do use some cheap trackers within my portfolio for 'general exposure'. But when a tracker firm produces a research paper that says tracker firms are great, you do have to read it carefully to see if what they say about the results they chose to highlight, is applicable to your investing situation, your decade, your market, your tax situation (US mutual fund vs UK, as mentioned above) and so on, and whether there are other counterarguments they have chosen to omit because they choose not to think that way.

puk999

dunstonh wrote: »

Here is a pretty good article to read. It wont change anyone's mind but it shows that there is more to it and that no-one should sit 100% in either camp but aim to use the best of both.
https://www.fidelity.co.uk/investor/markets-insights/fund-news/details.page?whereParameter=fundnews/active-funds-trounce-passive

Straying from the topic a bit, but that article says in the last 10 years FTSE 100 returned 115.2% while the FTSE 250 returned 254.17%. I didn't expect there'd be such a difference. What happened?

EDIT: Also, can't understand the 3rd graph on that link titled "Performance of average active fund vs tracker and index over 10yrs". The blue data line (A) terminates at > 250% but the legend says 106.11%.

ChesterDog

Smaller companies have had a really good run in the last year or two. Until a few months ago.