Passive v active

Seabee42

The FTSE 100 is not a very balanced investment, it is heavily weighted to commodities and financials as such the FTSE performance does well when they do and so on.

On the original topic there is an argument that it is better to invest in an active fund manager than with an active fund manager.

There is also research out there that if you want to invest in equities avoiding churn is beneficial in the long run, so maybe just buy a few good companies and hold them.....

guymo

jamesd wrote: »

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.

This paper would seem to confirm your point of view:
http://www.pensions-institute.org/workingpapers/wp1009.pdf

Summary: top performing funds are negatively affected by manager change and the growth of the fund. If you control for these effects, outperformance persists, but when both effects are present there is no persistence.

I don't hunt for this stuff much but this is the first paper I've seen which suggested there was any evidence of persistence. Interesting.

N1AK

dunstonh wrote: »

That is one side of it but the counter side is that a manager may choose to avoid a stock it feels is in decline and possibly failure whereas the tracker has to hold it until it is outside of the benchmark requirements.

There are too many positives and negatives with each.

That's exactly what I talked about, so I really don't get why you think it's the 'counter side'. Fund managers make judgement calls, I invest passively because I don't want to have performance determined by those judgement calls. Getting out of a stock, as in the example you give, is exactly the kind of thing I meant. Obviously many of the judgement calls will be right, but then so are many guesses when flipping a coin

N1AK

princeofpounds wrote: »

I think you miss the point. Picking any kind of passive fund is a judgment call in itself.

In fact it's probably a bigger judgment call in risk terms than what most active fund managers do vs. their benchmark, given it involves large volumes of asset allocation.

This sort of demonstrates my point actually, that there is this perception that picking a passive product is essentially risk-neutral.

I'd suggest you read other peoples statements more carefully. The last thing I would suggest is that any stock investment is 'risk-neutral'.

When you pick funds those funds will invariably include risk and a bias towards certain markets, asset types etc. It's unavoidable regardless of whether they are actively or passively managed.

However, when you buy an actively managed product there is an additional risk (or as some would see it reward): The judgement of the fund manager.

I'd agree completely that where and what you chose to invest in is a more important decision than active vs passive. But given that you can't invest without making a decision on where/what that's a risk you must accept if you wish to invest in stocks; the risks of other people's judgement calls are not.

princeofpounds

However, when you buy an actively managed product there is an additional risk (or as some would see it reward): The judgement of the fund manager.

This is only necessarily true if you define risk as relative to a benchmark, and any deviation from this benchmark as active risk.

It is not necessarily the case if you look at an absolute measures of risk, which is generally more important in terms of the actual investment experience that results.

As a very simple example, an active manager in emerging markets might employ a cautious, value and income-oriented strategy.

Is this actually riskier than a passive emerging markets index exposure?

Many people think yes, there is no active risk, by picking the passive product you are simply getting benchmark returns.

In reality, the index is actually substantially more volatile and risky.

To see the active risk as 'additional' risk is a mistaken understanding of how risk is defined; it is in fact simply the result of a decomposition of absolute risk into factors, such as an (entirely arbitrary) benchmark and active variables.

That decomposition is not actually an additive process, and it is a mistake to think of layers of risk adding up on top of each other, but this is the mental image most people use.

Now don't think that I raise this topic to promote active fund management. That is not the point at all.

The point is that arbitrary benchmarks are often seen as lower-risk for average return, when they are in fact only lower active risk and average return compared to themselves. And when you stop for a moment and think about that, you realise it's not much of an achievement. It's essentially definitional.

Let's look at some passive indexes:

The S&P and Dow Jones have diverged by 7% since the beginning of 2013.

MSCI UK ETF diverged from the FTSE All-Share by 6%.

These are substantial divergences - similar in scale to the active risk of an average actively-managed mutual fund in fact - amongst indexes that might all fairly claim to represent 'the market'.

Passive providers always bang on about average managers not being able to beat the index. I happen to agree with this, although I also think this is largely as informative as saying everyone in a population can't be above average height; again it is largely definitional.

My point is that active management cannot be escaped. You are always making decisions about what to do with your cash. When you pick your passive instrument you are taking an active bet on an index methodology and asset allocation just as much as an active instrument involves an active bet on a fund management strategy.

Passive products do have a transparent and mathematically consistent strategy I suppose (putting aside those pesky occasional changes in methodology!), so at least you know what you are getting into. And you already know I like low fees.

But I've never felt comfortable with the way benchmark products market themselves around risk. If you know a product has low active risk, it seems odd when you realise it tells you precisely nothing about how risky it is.

bowlhead99

Agreed; FTSE All share presumably has 2400x as much of its performance driven by Shell as is driven by Punch Taverns. The trackers may not even bother to buy Punch because it doesn't have any material effect on your overall performance -it gets lost in the roundings and tracking error.

It may or may not be appropriate for you to have much more money in oil than you do in a small pubs group.

The FTSE index gets you, as princeofpounds says, a mathematically consistent allocation strategy and the result of the "whole of market" return (at least if your market is only "99% of uk listed equities" and excludes bonds, commodities, direct property etc etc). So you don't have the "risk" that you wake up in the morning and breakfast telly says the market is up while your holding is down. But potential personal embarrassment is not a risk if you have thick skin. And in fact, you might be up more than the so called market in any given period of days.

Losing a larger amount of your capital than you can afford to lose, is a risk. Not making enough money in real terms to meet your goals, is a risk. Having your cash in too few pies and heavily dependent on a few individual companies, is a risk. Off the top of my head, half the value of the S&P500 is in the top 50 and two thirds of the UK all share (£1.6trillion of ~£2.4 trillion) is in our top 50. That sounds like quite a bit of concentration risk, even if the return from it is "representative of the whole UK equity market"

Having someone tell you the whole of market index return was a different number than your portfolio got, is not much of a risk. Consequently, you can select your portfolio differently without necessarily "suffering" in any way. In reality, active managers cost more in fees and have potentially high costs if there is a lot of churn, while an entirely DIY personal self-purchased direct holding portfolio has a lot of transaction cost if you are chasing diversification. So you do suffer in that sense but as dunstonh said many posts ago there are pros and cons. There are swings and roundabouts with the merits of index slavery versus the merits of freeform entrepreneurial exuberance.

atypical

masonic wrote: »

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.

They haven't done this. They have compared sector by sector.

dunstonh wrote: »

One has to remember that the Vanguard research, like so many, is based on the US market.

This research was produced by Vanguard UK and only considers the UK market.

dale_cotterill wrote: »

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.

If they were overvalued the market would correct for that. That is what a passive fund relies on (i.e. the collective value decisions of the thousands of people who trade) vs any individual fund managers decision. When I ask myself who is more likely to be wrong, I think it will be the latter as research seems to confirm.

SlapShot

Interesting comments! Bit late to this, but I found a couple of really good blog articles on this topic and thought I'd share:

http://pragcap.com/why-most-passive-index-fund-advocates-are-hypocrites
http://pragcap.com/we-are-all-active-investors-part-2
(There are more in a similar vein on his site).

Needless to say, I'm sympathetic to this view and use a healthy mixture of passive and active funds in my own portfolio, as appropriate and according to the availability of funds and the risk/inefficiency present in each market.