Active vs. Passive. When and Where?

redbuzzard

I'm a fan of Tim Hale and quite prepared to believe he is "right" in his analysis. But you might not want market volatility all the time. At the moment I am happier to hold some equity income / general equity funds principally because of that.

The point has also been made that there is not always a passive option - e.g. Capital Group's EM Total Opportunities Fund, a multi asset fund which is not intended to be a blend of an equity fund and a bond fund, but is run with regard to the best way of investing in specific markets and also uses currency hedging.

Chickereeeee

232607 wrote: »

.....you can't really do active in certain sectors life property or under valued funds. ...

Does not a large part of the active/passive debate imply there is no such thing as an undervalued fund? They are valued (or rather the holdings are) at what the market says they should be.....

Other wise you are saying that you or certain managers have magic knowledge that no-one else has.

C

Linton

Chickereeeee wrote: »

Does not a large part of the active/passive debate imply there is no such thing as an undervalued fund? They are valued (or rather the holdings are) at what the market says they should be.....

Other wise you are saying that you or certain managers have magic knowledge that no-one else has.

C

It doesnt have to be knowledge no-one has, but rather knowledge that only a minority have. In small companies this is certainly the case where the fund managers can have personal contact with the company management and there is little news available to the wider public. Most of the global market isnt interested anyway as the companies would be too small to be worth investing in. Similarly with the smaller EM markets. Also property funds that invest directly in property rather than property companies would have detailed knowledge of the locations of their property - a level of detail below which "the market" neither knows or cares.

For large companies in the large markets, sure, detailed information is widely disseminated and their size makes it worthwhile for the market to take a deep interest. So if that's what you want to invest in go passive.

Another difference between the market and the investor is that the market is strongly driven by short term events. That is how the big boys earn their money. Investors can, and probably must, take long term views. I am unaware of any proof that a market priced for the short term is necessarily optimal for the long term.

I am not wildly anti-passive or wildly pro-managed. I dont care very much about that and about lots of other ways one could categorise funds. Its more that in the overall scheme of things these factors are of much lesser concern than asset allocation.

Chickereeeee

Linton wrote: »

It doesnt have to be knowledge no-one has, but rather knowledge that only a minority have. In small companies this is certainly the case where the fund managers can have personal contact with the company management and there is little news available to the wider public. Most of the global market isnt interested anyway as the companies would be too small to be worth investing in. Similarly with the smaller EM markets. Also property funds that invest directly in property rather than property companies would have detailed knowledge of the locations of their property - a level of detail below which "the market" neither knows or cares.

For large companies in the large markets, sure, detailed information is widely disseminated and their size makes it worthwhile for the market to take a deep interest. So if that's what you want to invest in go passive.

Ah you mean small companies, start-ups etc, rather than undervalued per se.

[FONT=&quot]I have a lot of experience in that sector. A fund manager generally has not a clue about if a start-up will be successful or not. Most start-ups are not, although they (managers, investors, fund managers etc) all believe they will be.[/FONT] Similarly there are MANY small companies and picking a 'winner' from the sub-set that the fund manager knows about is not predictable.

Probably a micro/small cap fund tracker would outperform the average fund manager in this sector as well.

C

Thrugelmir

HSVX wrote: »

So let's say in this case you are not going to need money from the portfolio for a very considerable amount of time (20+ years) and all you are trying to achieve is maximum capital growth. How does that change your perspective?

60% of stock market returns come from reinvesting dividends. Focusing on growth alone means little.

masonic

Chickereeeee wrote: »

Does not a large part of the active/passive debate imply there is no such thing as an undervalued fund? They are valued (or rather the holdings are) at what the market says they should be.....

Other wise you are saying that you or certain managers have magic knowledge that no-one else has.

C

I don't think that conclusion necessarily follows from the premise that funds can be undervalued. The obvious example is the investment trust that may be trading at a significant discount (or premium) to its net asset value. This is primarily driven by investor sentiment, such that trusts that are in sectors currently out of favour will tend to trade at discounts, but move to premiums during better times. Similarly, a company could be valued by the market as significantly less than the sum of its parts as an extreme example.

There is a psychological element to short time price movements, so there are plenty of examples of prices becoming temporarily disconnected from reality that could be exploited, at least theoretically. There is also fairly compelling evidence in favour of certain value-based strategies being very successful over long periods, but typical retail fund managers are unlikely to be in an environment where they could wait that long before delivering results. The trouble is that any evidence based on past performance is impossible to differentiate from chance.

Chickereeeee wrote: »

Ah you mean small companies, start-ups etc, rather than undervalued per se.

I have a lot of experience in that sector. A fund manager generally has not a clue about if a start-up will be successful or not. Most start-ups are not, although they (managers, investors, fund managers etc) all believe they will be. Similarly there are MANY small companies and picking a 'winner' from the sub-set that the fund manager knows about is not predictable.

Probably a micro/small cap fund tracker would outperform in this sector as well.

C

There are a few reasons why it may not. A tracker using physical replication is likely to have proportionately higher costs than the typical S&P500 or FTSE All share tracker, more difficulty operating in the less liquid environment, and if market-cap weighted, will typically hold larger companies than the other funds in its sector (and for this reason, if you believe in a small-cap premium - which you should if considering such a fund - you might expect lower returns as a result).

Coming back to the original question, there are a few reasons why I might not select a tracker for a particular market sector, most of which have already been mentioned:
- Lack of diversification / significant (industry) overweight/underweight in the index
- Tracker contains assets to which I want to avoid exposure
- Market cap weighted approach inappropriate - e.g. for small cap exposure
- Tracker is unavailable / expensive
- Existence of very cheap active funds

The last one is a very recent factor, given the total cost of ownership of passive funds has gone up (platform fees), meanwhile some active funds have taken the opportunity to really slash their fees.

Linton

Chickereeeee wrote: »

Ah you mean small companies, start-ups etc, rather than undervalued per se.

[FONT=&quot]I have a lot of experience in that sector. A fund manager generally has not a clue about if a start-up will be successful or not. Most start-ups are not, although they (managers, investors, fund managers etc) all believe they will be.[/FONT] Similarly there are MANY small companies and picking a 'winner' from the sub-set that the fund manager knows about is not predictable.

Probably a micro/small cap fund tracker would outperform in this sector as well.

C

I am not talking about startups. Small Company funds dont normally do start-ups. That is a totally different sector. The UK microcap sector judging by funds with microcap in their name covers companies in the £50M-£250M range.

Name a micro/small cap tracker - a bit difficult perhaps. Lets use the FTSE Small Cap Index instead which seems to be in a similar ballpark:

FTSE Small Cap Index up 127% total return in 10 years. If it was in the UK Small Cap sector it would be around 32nd out of 36 funds. Marlborough Microcap up 286% in 10 years.

232607

Chickereeeee wrote: »

Does not a large part of the active/passive debate imply there is no such thing as an undervalued fund? They are valued (or rather the holdings are) at what the market says they should be.....

Other wise you are saying that you or certain managers have magic knowledge that no-one else has.

C

I agree with what you're saying, I think it was my terminology that was not clear. The sort of funds I was referring to are recovery funds that focus on companies who share price has had a major drop. The fact sheets of these funds often use the term under valued when of course the market has fully valued them.

Regards

bowlhead99

232607 wrote: »

I agree with what you're saying, I think it was my terminology that was not clear. The sort of funds I was referring to are recovery funds that focus on companies who share price has had a major drop. The fact sheets of these funds often use the term under valued when of course the market has fully valued them.

You probably confused things when you said "you can't really do active in certain sectors life property or under valued" when you meant you can't really do passive in those sectors (and I assume life was a typo for like)

Undervalued can mean out of favour sectors, or individual companies presenting potentially lucrative 'recovery' opportunities (e.g. special situations funds). There are no trackers which really focus on that space, though in certain parts of the economic cycle it can be something in which many professional and institutional investors happily participate, through managed funds.

--
What follows will be another trademark long post; I've written plenty on active vs passive in the past so if you use an advanced search you could find it. I have some passive funds across my portfolio together with active funds, but like most reasonable people I see the merits of both strategies for different situations. I do own Tim Hale's book, and also other books written by people who are not passive investing evangelists. So, some of my posts are simply playing devil's advocate when someone has a particularly strong view that their way is right because "there is plenty of research that proves beyond a doubt that my way is right.." or "it logically follows that...".

--

Overall if OP is just going to have a goal of maximisation of total assets over a very long time period without regard to whether that is achieved by income, capital growth or currency movement, it would make sense to have a healthy allocation to a very wide set of sectors, geographies, asset classes and investing styles, as no one allocation will prevail in every market condition and it is impractical to rotate between baskets all the time if one doesn't know what basket will be 'best' over the next year to come. With a long term view, most of the money should be in equities rather than fixed income or real estate or commodities, and then within equities there is a very wide choice of what to hold.

Holding one single global equity tracker focusses the money into the mega-cap companies which are [generalising] more likely to sit there as cash cows than deliver high growth multiples. Mid-cap and smallcap companies generally do relatively better in boom times (though worse in bear times, but over the long term things grow rather than contract), and so with a goal of long term asset maximisation, even someone believing in passive indexing will stratify their holdings and index the large caps separately from the mid caps and the small caps - because the cost to rebalance is insignificant compared to the disparity in return between the different parts of the market.

As you get to the smaller end of the scale, there are practical problems associated with deploying large amounts of money into smaller and smaller companies whose shares are illiquid. Also, the lack of public research and market information means that trusting allocation to an index of what 'the market proportions' are, is inherently more flawed; the market is inherently less efficient at valuing and allocating capital when it doesn't know all the facts.

It is true that as Chickaree says, 'picking a winner' from a set of small, unproven companies is difficult, but a manager with a research team can at least uncover facts which may point to the company not being one of those which simply has a low market cap or low p/e because it's going down the pan. Avoiding losers is at least as useful as picking winners and there are few if any smallcap and microcap trackers because the merits of passive investing in this space are dubious.

Smallcap developed markets and allcap emerging markets are areas in which the cost of an investment team 'on the ground' can reap rewards in terms of avoiding all the crapola in the index.

For example there might be a large Chinese company with a stupid management team, poor corporate governance and a bunch of problems lined up in its future. The market should price it lower than a better run company, but its sheer scale could result in it being a meaningful percentage of the index.

As investors are idiots, this can resulting in it getting a wall of incoming cash from investors who 'just want exposure to emerging markets because they are high growth' and will throw money at anyone who claims to be an investment manager in China or will allocate their cash in any way at all into the Chinese markets. Such investors may be disappointed that the company doesn't do very well; but in the good times the growth from a not-very-good Chinese company might still be outpacing a good Western company and they will keep on plugging away with their index approach or their naff active China manager. Meanwhile, the good active China / EM managers become quite easy to identify from their track record.

In China, Brazil, India, the top 10 companies in the country's main index make up half the market cap of the index - small companies are nowhere. In Russia that ratio is even higher. Compared to S&P500 where the top 10 are dominant but under 20% of the index overall. So, if you fancy investing in emerging markets because of particular views you hold about the economies or demographics or direction of development, is it really possible to use index-tracking in emerging markets to capture those investment themes to which you subscribe? There are always pockets of great opportunities for investors who look beyond the largest companies (some of which are state controlled, some of which are massively driven by oil or materials prices). Likely, active funds are better placed to capitalize on those themes and the best growth opportunities in such locations.

So, while it might be true that it is difficult to find, in advance, the managers which will be best at finding the stars or avoiding the dogs, rather than the managers which will be unlucky and be on the wrong side of all the trades, it is possible to examine the 10yr+ track records of fund houses and make useful conclusions. The conclusions are of course more meaningful if they're made over more economic cycles and with stability of management team.

So to answer the question from the OP on where to use indexes:

- it is less easy to pick a future winner from the fund managers operating in the generalist largecap developed market space, so that makes the generalist largecap developed market space the most obvious place to use indexes. But of course most people have plenty of money outside the generalist largecap developed market space when looking ahead 20-30 years and being tolerant of volatility in pursuit of growth.

- even in the developed markets you may prefer to pay an active management fee to reduce the volatility that comes with concentrating large proportions of your money into a limited number of companies or sectors ; FTSE100 for example is terrible for spreading your money evenly across the different types of businesses that make up the world.

- poorly developed markets are obvious candidates for active management. Some companies in MSCI EM index like Samsung or Taiwan Semiconductor are very well known and operate just like other megacaps. But generally in developing countries, quality of corporate information is not so good, and even access to markets themselves for outsiders can be limited (especially in frontier markets).

- some sectors and investment styles are well under-served by indexes, or even if indexes from FTSE (http://www.ftse.com/Analytics/factsheets/Home/Search) or MSCI or someone else exist to track the statistics, people haven't actually turned them into investment products that are cheaply and easily accessible from the UK. So sometimes your hand is forced by an index not being available.

- For example, how would you get access to the x% of global corporate assets and income streams which are not owned by public listed companies, if you had to use an public markets 'index' instead of a private equity manager? How would you construct an absolute return or hedge fund to target a positive absolute return across market conditions, without making active decisions along the way or providing feedback as to what the conditions actually were?

- The range of passive products is always improving - which is a good thing for investor choice - but some such products are arguably not very passive at all, as the product provider has made some arbitrary and proprietary rules to facilitate cheap access to (e.g.) an equity income portfolio; they'll happily set it up based on back-tested performance, but if they are not monitoring how it performs against its objectives to refine the methodology, it might not do very well. And if they do refine it as they go along, it is not passive.

Personally, as I'm not 'the whole market' trying to deploy $50+ trillion across the global equity markets or £2+ trillion across the UK, I have no need to weight my exposures to the largest companies across the planet. So I'm generally not a fan of shaving off a few tenths of a percent from the management fee to find the absolute cheapest way of getting my money into the market and thereby adopting a strategy which gives most of it to Apple or whoever is flavour of the year on a market-cap basis.

I have more interest in the indexes which are equal-weight rather than cap weight, because that will give a proportionally greater allocation towards the smaller ones. It is not so much a desire to put more money in particular small companies, just a desire to not put extra money in particular larger companies simply because they are large. There are few equal-weight products around, because they are inherently more expensive to operate - certainly they can't be rebalanced daily, more likely quarterly. The MSCI size factor ones are not bad for general exposure (iShares do an ETF for European mid-cap for example).

I quite like the idea of saying I don't know what company will do best so I'll put a pound into everything, rather than I don't know what company will do best so I'll allocate all my pounds the way 'the market' allocated its pounds ; the market is made up of people with very different objectives to me.

The efficient market hypothesis says the market will price things 'right'. So, presumably today's price for Royal Dutch Shell (£128bn) is fine, as is today's price for Enterprise Inns (£688m). Both of them could be profitable investments from today's fair price; one currently pays dividends, one used to and currently doesn't but has growth potential, but basically the market is happy with both prices for the risks and rewards they present. Both are in the FTSE350 and I could buy either of them on a monthly purchase plan for £1.50 a month with my broker.

Or I could simply buy an index ETF from my broker. In the index product, I get 185 times as much of the oil giant as I do of the pub chain, even though the current price allegedly values the prospects of each fairly and so Shell is not a particularly good opportunity and Enterprise is not a particularly bad one. This seems a bonkers allocation, hence I don't use a FTSE350 index as the primary way of running my UK equities exposure, even though the UK is a 'developed market'.

grey_gym_sock

in general, start with asset allocation, and then consider whether each allocation is best covered passively or actively. though if all the options for some allocation are very expensive or otherwise problematic, it may make sense make that allocation smaller or leave it out. IMHO, you should aim for very low average costs for the overall portfolio - because costs can be controlled, but performance is always a guess - and that usually implies mostly passive.

what kind of allocations can't be covered passively, even in theory? not many. private equity (i.e. unquoted companies) can't be. direct property can't be (though quoted property companies can - and personally i prefer the latter). i think that's about it.

smaller companies via a capitalization-weighted tracker may seem illogical (why put more money in the bigger-capitalization smaller companies?), but it works: it's cheap, and it gives you exposure to small companies. however, if you want UK small companies, there are no trackers available (AFAIK: there are mid-cap - FTSE 250 - trackers, but not e.g. FTSE Small Cap).

there are fair questions about how well small cap trackers work, given the bigger trading costs of small companies. but they certainly can be made to work. an equal-weighted small cap tracker will in theory give you better exposure to small cap, but it will incur higher trading costs: is it worth the higher costs? IMHO, it's not obvious either way. the usual cost advantages of trackers are of 2 kinds: lower explicit charges (TER/OCF), and lower internal trading costs. an equal-weighted tracker will give up some of the latter advantage. (this can be an issue with many of the more complicated tracker products that have been launched recently; some of them are more like active products in disguise; they are best used sparingly, if at all.)

i don't agree that the less exhaustive research into smaller companies is a good reason to go active. arithmetic still implies that a properly constructed tracker (if 1 exists) will match the index (before costs), and so will the average active investor (before costs). so assuming passive is cheaper than active, passive will beat the average active investor after costs. to justify going active, you need to think you can pick a better than average active approach. you need to identify the winners, or (equivalently) identify the losers so as to rule them out.

now, it is possible that active funds (collectively) do better than average, because active private investors do worse than average. actually, i suspect this is true in aggregate, including for big cap shares - but that is only before costs. and nowadays, there is many times more money invested by professionals (via funds) than by private investors; so there might be £10 of professionally managed money making gains at the expense of every £1 of amateur money. as a result, the gains are likely to be less than the higher costs of active management. however, this does suggest that active management might be worth considering in any markets which are still dominated by private investors (dunno where that would be).

"value" investing can mean various things, but it is not necessarily inconsistent with passive investing. it can mean distressed companies, which are in danger of going out of business, or just of gradually becoming smaller and less profitable, but are priced accordingly, and therefore on average are likely to give good returns, starting from the current low share price, but with higher risk. there are a few passive products that attempt to capture this effect by mechanically selecting shares that are priced cheaply relative to their current earnings, or assets, or whatever. there are also active approaches to "value". IMHO, what to pick depends very much on what's available.

investing for income is something which can be done passively. there can be issues with excessive concentration (in sectors, and in individual shares), but i think that's more of a problem with the UK dividend payers - a large proportion of dividends come from a few huge companies - than with the passive approach. active UK equity income funds can also be very concentrated. if you go global, vanguard's all-world high dividend yield fund is very diversified. so i'd say the answer is to rely less on UK equity income, and also look outside the UK, and (shock! horror!) at bonds.

emerging markets are an area in which i use a bit of active. this is basically because i don't like emerging markets in general. higher risk (actual risk, not just volatility); poorer corporate governance; the absence of any positive relationship between higher economic growth and higher equity returns; and the absence of any observable difference between returns from developed and emerging markets in the very long term (i.e. over c. 100 years). but perhaps this should be a debate on another thread ... the point is that i have a small holding of aberdeen asian small companies (AAS), because they seem to filter by some of the factors which put me off emerging markets more generally (i.e. competent management; companies run in the interests of shareholders). it's more expensive than a tracker, but then i only have a small holding of it, and it's rather different from my other holdings.

general things i'd look for in active managers: a strategy which is simple enough (in broad terms) that i can see how it might work, and which the same manager or team has been following for at least 10 or (preferably) 20 years. and i'd usually prefer a low rate of turnover of holdings (though this is dependent on strategy).