Active vs. Passive. When and Where?

Jsscmm

Not sure if this would be small cap enough for you ggs (the definition of small seems to be unclear, at least to me) but iShares MSCI UK Small Cap UCITS ETF (GBP) CUKS, as according to Morningstar, is the only UK small cap etf my sipp can use.

Not a recommendation of course, just pointing out that this exists, which was admittedly a surprise to me.

bowlhead99

MSCI UK smallcap basically goes from companies at the bottom of the FTSE 100 (the top ten holdings currently have £3-5bn market cap, like Barratt, Taylor Wimpey, St James's Place) - down to smaller AIM or main market stocks in the £300m range like Mothercare or Majestic Wine. The bottom end is lower than the FTSE250 goes (FTSE350 exit position would be around position 375 in the rankings, about £540m at the moment).

Overall the companies in that MSCI index have an average size of £1.14bn. Compared to FTSE250 index, where average size is £1.38bn. Looking at median company size, MSCI Small is £0.85bn while FTSE 250 is £1.05bn, although medians are probably not so relevant when it's a cap weighted index; they just give a sense of how many small companies are getting a low weighting. In the MSCI index the truly small companies like the Mothercares or the Majestic Wines or the Stobarts are each only 0.1% or less of the index, so while that's a greater showing than they have in the FTSE 250 (where they are 0.0% of the index), they each contribute virtually nothing - could double overnight without making a meaningful difference to your annual return.

So, the MSCI index is an index with about 250 holdings which is a competitor to FTSE's 250 index, obviously doesn't have the exact same constituents otherwise there would be no point them creating it. But, you probably shouldn't be surprised it exists because it is indexing a bunch of investible and liquid companies with half a billion to five billion pounds of capitalisation. What it's not doing is indexing just those companies that sit below the FTSE 250 (i.e. as the difference between FTSE 350 and FTSE All-Share).

You could probably think of it as a UK-Allshare ex-FTSE100 index and as such it might fit someone's strategy. Both it and FTSE250 give you about 14-15% of the free-float adjusted market capitalization in the UK.

grey_gym_sock wrote: »

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.

The average of all investors will give the result of the cap-weighted indexes.

Some of the 'active investors' are private investors who allocate their portfolios without rational thought as to fundamentals and overall allocation (e.g. holding employee sharesave shares, bonus windfall shares, shares they heard about from their mate down the pub, shares they inherited, shares they got in a Royal Mail or Direct Line or TSB IPO because it seemed like a good idea at the time even though they don't think of themselves as an 'investor').

Some of the 'active investors' do not have free choice in what to invest in, because they are attempting to deploy large amounts of money and really do have to weight their portfolio towards larger or more liquid stocks. For example the institutions as a whole really do need to put 20x as much into HSBC as they do in Taylor Wimpey in the FTSE 100 indexes, or 20x as much in Taylor Wimpey as they do in 888 Holdings in the MSCI smallcap indexes. Because they can't allocate their portfolio the opposite way around even if they felt 888 was a better opportunity than HSBC.

So they end up with a lot of HSBC. It doesn't mean that having researched the opportunities of growth and profitability prospects and regulatory hurdles etc, you should also buy a lot of HSBC, unless you are aiming for the return of what the large pension fund or insurance company or government sovereign wealth fund is going to achieve from 'the market'. If you are managing a nimble £50m investment trust you can get away with investing each of those millions in pretty much whatever the heck you like.

Some of those 'active investors' are actually closet trackers, who are following an approach quite close to the index by weighting their portfolio similar to the index so they don't get criticised for losing to the index too much from one period to the next, with the result that their half a percent of fees is dead money so their performance is poor.

So, while you can easily see that mathematically, all investors will on average end up with the same as 'the index' and therefore it sounds foolish for them to pay active management fees to achieve that end - many of us don't aspire to end up with the same result as the index. Some people have specific needs (e.g. income, low volatility etc) so won't follow the index. But others won't follow the index because they are simply looking for more outright performance than the average of what the big institutions, closet trackers and idiot private investors are destined to achieve.

If you can avoid the actively managed funds that turn out to be closet trackers or dogs - which is easier said than done but is not an impossible task - you can beat the indexes by enough to pay the fees. Quite what level of overall fees (annual fee, annual operating expenses, capitalized trading costs, performance fee etc) can be afforded and still beat the index net of fees without taking too much risk, is unknown, but there are plenty of managers who regularly outperform trackers in some sectors.

So my contention remains, that where the markets are imperfect, a good manager can reliably beat the index. Clearly that's harder to do in developed markets which are large and liquid. So large and developed markets would be the best place to use indexes - assuming you don't have a goal that precludes their use, e.g. higher income, lower volatility etc. Which comes back to smallcaps and emerging markets (and especially smallcap emerging markets, if your portfolio is broad enough to entertain them) as being the relatively better places to be an active investor or pay an active manager.

Linton

grey_gym_sock wrote: »

....
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.

......

According to the Vanguard website Vanguard's All World ETF has a yield of 3.13%. Roughly the same as the FTSE 100 or All Share. Hardly a must buy for an income investor.

Perhaps you can give an example of a diversified passive income portfolio.

BLB53

Hardly a must buy for an income investor.

I invest for income but have realised I am closing down options by focussing just on looking for natural yield.

I prefer a globally diversified option as obviously the UK market cannot consistently provide the better returns.

I hold the Vanguard All World ETF which offers a natural yield of ~3.5%. I also hold a few investment trusts which give a natural yield of ~3.8%. I also hold the Vanguard LifeStrategy 60 which gives a good mix of equities/bonds which are automatically rebalanced.

The natural yield is only ~1.4% which the conventional 'income' investor may dismiss but the average return since inception in June 2011 has been over 9% p.a. so at the end of each year I will sell off some units to provide me with 4% 'income' I need.

As an 'income' investor, I think it makes sense to look at total return which is more likely to be generated by the lower cost index funds/ETFs and consider the option of selling off some of the capital where the natural yield is too low.

masonic

BLB53 wrote: »

The natural yield is only ~1.4% which the conventional 'income' investor may dismiss but the average return since inception in June 2011 has been over 9% p.a. so at the end of each year I will sell off some units to provide me with 4% 'income' I need.

As an 'income' investor, I think it makes sense to look at total return which is more likely to be generated by the lower cost index funds/ETFs and consider the option of selling off some of the capital where the natural yield is too low.

This seems to be quite an unpopular view, although I can't imagine why. I've always been quite bemused by those who are happy to have dividends of 4-5% per year or more paid out to their bank accounts, but the thought of selling any capital to supplement income is abhorrent to them, even if the growth is well ahead of other high income holdings. You see a similar theme amongst savers in a low interest rate, low inflation environment.

Chickereeeee

masonic wrote: »

This seems to be quite an unpopular view, although I can't imagine why. I've always been quite bemused by those who are happy to have dividends of 4-5% per year or more paid out to their bank accounts, but the thought of selling any capital to supplement income is abhorrent to them, even if the growth is well ahead of other high income holdings. You see a similar theme amongst savers in a low interest rate, low inflation environment.

On a related note, is it likely that high dividend stocks will be hit harder than others as interest rates rise and the 'search for yield' decreases?

C

Linton

masonic wrote: »

This seems to be quite an unpopular view, although I can't imagine why. I've always been quite bemused by those who are happy to have dividends of 4-5% per year or more paid out to their bank accounts, but the thought of selling any capital to supplement income is abhorrent to them, even if the growth is well ahead of other high income holdings. You see a similar theme amongst savers in a low interest rate, low inflation environment.

My reason for relying on natural yield is twofold:

1) It needs virtually no management, perhaps a rebalance once per year and the very occasional replacement of those shares that cease to pay dividends. Apart from that the money comes into my bank account automatically on a fairly regular basis.

2) Controlled diversification of income. I hold both an income portfolio, 60% UK shares and 40% a broad global range of income paying funds, and a high risk/high return portfolio from which I withdraw a large lump sum annually as part of the annual review. I choose how much money to have in each portfolio and can rebalance between the two as desired. This is worthwhile doing as the two portfolios hold very different investments.

Linton

Chickereeeee wrote: »

On a related note, is it likely that high dividend stocks will be hit harder than others as interest rates rise and the 'search for yield' decreases?

C

I dont think so - dividends are still at a reasonable % unlike bonds. In any case a decrease in capital value is not a serious problem to an income investor as it doesnt directly affect income. Perhaps another reason for not relying on selling capital to provide an income.

masonic

Linton wrote: »

2) Controlled diversification of income. I hold both an income portfolio, 60% UK shares and 40% a broad global range of income paying funds, and a high risk/high return portfolio from which I withdraw a large lump sum annually as part of the annual review. I choose how much money to have in each portfolio and can rebalance between the two as desired. This is worthwhile doing as the two portfolios hold very different investments.

Unless I am misunderstanding what you are doing with your "high risk/high return portfolio", then it seems you are selling capital when appropriate and using profits from the growth of that portfolio to supplement your income stream (though it may be indirectly, by replenishing your cash reserves or topping up your other portfolios). I can completely understand cascading capital through one or more buffers that you can fall back on during times when you would otherwise be forced to sell capital at an unfavourable price.

masonic

Chickereeeee wrote: »

On a related note, is it likely that high dividend stocks will be hit harder than others as interest rates rise and the 'search for yield' decreases?

So your premise here is that there are people who are perhaps reluctant HYP investors who are poised to sell up and buy cash/bonds if the rates become more attractive? This would probably have a very minor effect (what proportion of the company's shares are held either directly or indirectly by these people? - probably a very insignificant number), and it would require quite a large hike in rates to come about (which seems very unlikely based on current expectations).