Active vs. Passive. When and Where?

BLB53

But actually there we agree. Most investors just want to put money in and forget about it, so active managed funds are not a good match for their inclinations. You rally do need to be paying at least enough attention to read the manager changed email notifications, for example.

Personally I use both active and passive funds.

I also use a mix of passive and active but I am leaning more towards the passive camp as I become more and more persuaded by their lower costs and consistency.

I do however stand by my original post in this thread...

Most active funds fail to consitently beat the index over the longer periods - admittedly, some managers do manage this but it is difficult to pick them out at an early stage.

You therefore have maybe a 5% or at best 10% chance of selecting a long term winner from the thousands on offer or a 100% of matching the index with a low cost tracker.

Warren Buffett suggests most amateur investors will be better off with a low cost index fund.

The best returns from the managed sector are smaller companies, so there will be more logic to including these alongside a portfolio of mainly globally diverse trackers.

..to be fair though, it should of course be stated that index funds have to make a charge and therefore cannot fully match the index they track as it will inevitable fall short by at least the level of charges. I think this almost goes without saying, but to say the tracker will have a 100% chance of matching the index is, I concede, factually incorrect.

I really do not wish to detract from this thread by getting drawn into a line-by-line analysis of what was intended to be an off-the-cuff comment attempting to do my level best to assist the OP and other readers by posting my point of view. Were I composing a dissertation on the subject, I may take a little more time over the exact wording.

Rollinghome

jamesd wrote: »

Personally I use both active and passive funds.

Well done James!

As the previously most religiously fervent antagonist of passive funds on this board, that's quite a step. Whatever next.

Radiantsoul

There is overwhelming evidence that active mutual funds in the USA have performed poorly. So it is now assumed that the USA is a "better" market and so it is harder to outperform the index. Probably the most famous research is Carhart:on the persistence of mutual funds(1997).

An alternative explanation is there is more data for researchers to mine and so more research has been undertaken in the USA. Where research has occured in the UK it seems to arrive at similiar conclusions.

It may be possible that some funds in smaller areas may be able to make larger returns for a while in smaller markets that are supposedly more inefficient, but they would encourage additional funds to flow in and so make it harder to fish in these shallower pools. And it may simply be that is more research is undertaken we will find that net of costs active funds underperform in the small cap and developing world space.

I don't believe that a simple strategy such as watching the manger, looking at p/e ratios, reading the promotional literature, etc is going to allow a retail investor to beat the market after adjusting for risk. Even if some managers do have skill at picking stocks it is impossible to identify them before hand.

jamesd

Rollinghome wrote: »

As the previously most religiously fervent antagonist of passive funds on this board, that's quite a step. Whatever next.

You're a relative newcomer so you might not remember me looking at the performance of the top ten active managed funds in the global growth sector back in 2007. Outperformance of the top ten persisted for years unless there was a manager change.

jamesd

Radiantsoul wrote: »

There is overwhelming evidence that active mutual funds in the USA have performed poorly. So it is now assumed that the USA is a "better" market and so it is harder to outperform the index. Probably the most famous research is Carhart:on the persistence of mutual funds(1997).

That study is pretty much useless except as a tool for promoting passive funds:

1. It doesn't control for human manager changes
2. It doesn't study the effects of using common guidelines like avoiding the dogs on performance of active managed funds.

It does a cursory look at persistence of top decile funds and notes some continued outperformance but doesn't control for the manager changes that at least for UK global growth funds were the dominant cause of failure to sustain outperformance.

In short, it's written from a convenience of analysis and passive viewpoint that fund managers don't matter, not bothering to analyse what happens when they do.

I'd agree that there is an overwhelmiong number of studies supporting the view, just none that I've seen properly controls for the things that are significant in active fund selection, so they are all useless for anything except promoting passive funds or getting academic publication credit for scholarly promotion criteria.

Radiantsoul wrote: »

An alternative explanation is there is more data for researchers to mine and so more research has been undertaken in the USA. Where research has occured in the UK it seems to arrive at similiar conclusions.

Are you sure you picked the right study, since the abstract for that one says in part that:

"Our study points to the existence of stock picking ability among a relatively small number of top performing UK equity mutual funds (i.e. performance which is not solely due to good luck). At the negative end of the performance scale, our analysis strongly rejects the hypothesis that most poor performing funds are merely unlucky. Most of these funds demonstrate ‘bad skill’."

That is, it appears to support the views that active funds can persistently outperform an index and that selection of active funds can be improved by avoiding the consistent dogs.

I didn't pay to read the whole article but I assume that it has the usual fault of not controlling for human manager changes and that the performance of selected funds would improve once that is allowed for.

Radiantsoul wrote: »

It may be possible that some funds in smaller areas may be able to make larger returns for a while in smaller markets that are supposedly more inefficient, but they would encourage additional funds to flow in and so make it harder to fish in these shallower pools.

I don't think that the market gets much bigger than the whole world covered by the global growth sector and there was strong persistence of outperformance in that sector when I looked at what happened to the top-performing funds in 2003 in the following years, with manager changes being the dominant factor in substantially changed performance.

Radiantsoul wrote: »

I don't believe that a simple strategy such as watching the manger, looking at p/e ratios, reading the promotional literature, etc is going to allow a retail investor to beat the market after adjusting for risk. Even if some managers do have skill at picking stocks it is impossible to identify them before hand.

It's hardly impossible to identify managers that have skill before investing, we had plenty of time to notice that Neil Woodford has done well and similar for Anthony Bolton until he changed where he was investing and invalidated past performance data. That doesn't appear impossible to me, nor did it to the investors who made theirs some of the most bought funds in the UK.

You may not believe these things but they have happened. Except for that bit about adjusting for risk: the managers may have been taking more or less risk than the market, with Woodford in particular well known for taking much less risk than the dotcom market around 2000.

Linton

I agree with James that these studies, or at least how they are reported, seem deeply flawed. If you want to meaningfully compare passives and active funds you need to have other factors constant. This is almost impossible.

Funds in any sector include a wide range of investment strategies. Some funds are significantly more or less volatile than others. Higher volatility theoretically implies higher long term performance. Different global funds choose different % country allocations. Some EM funds focus on Latin America others on South Asia. There are industry biases. A UK tracker will have a higher % of extractive industries than many active fund managers would be happy with. The most successful UK funds have very different company sector allocations to the FTSE indices. The definition of "Small Companies" varies. Then as Jamesd advocates you have the factor of the apparent skills of a few managers and the long term incompetence of a few others.

These factors are far more significant than what is nowadays post RDR perhaps a 0.5% difference in charges.

I would agree with the passive view that for a small/inexperienced investor broadly based passives are a reasonable policy if only because it prevents completely foolish choices. However once one has a reasonable amount of money to manage focusing on what the fund invests in is the best approach, whether the fund is active or passive is a secondary concern.

masonic

There is an interesting whitepaper from Vanguard that has some data relevant to this discussion: https://advisors.vanguard.com/iwe/pdf/ICRTPX.pdf?cbdForceDomain=true

Essentially, the argument presented is that you eliminate high cost active funds, you significantly improve the proportion of the remaining funds that outperform. In this case, they are using their own actively managed funds, which have charges of about 0.5% on average (a little cheaper than can be obtained here in the UK, but not much cheaper).

Looking at Figure 6 from the link above, the median Vanguard active fund outperformed its benchmark by 0.51% (annualised) after fees between 1997 and 2012, which is a 0.71% outperformance compared with a passive portfolio with an average cost of 0.2%.

If you look at the 75th and 25th percentile, then range of outperformance spans +1.30% to -0.59% vs. -0.14% to -0.38% for respective index trackers.

grey_gym_sock

bowlhead99 wrote: »

From the example above, perhaps all the truly unfettered managers could prevail against the restricted active managers, institutions and private individuals, but what is more likely is that some will prevail and some will fail. The ones that fail often, or fail enough to not beat their fees will fall out of favour and may close, but even if they don't close they will have a track record that lags the market or at least lags the top active managers.

in a sense, the basic issue with picking a winning active manager is: if this is the winner, who are the losers? (and they aren't the trackers, or the closet trackers.)

1 theory could be: the losers are private investors. as i've argued, this is plausible, except that there aren't enough PIs.

you seem to be suggesting that the winners could be the truly unfettered active managers, and the losers the restricted active managers. it's a theory. i doubt it's correct, mainly because most restricted active managers are working within a 2-level active management system: somebody (or some committee) allocates capital to various areas (e.g. UK big cap, UK small cap, etc), and then somebody else manages the money within each area. it's professional managers at both levels, so i don't see why a single manager (or team) covering both levels is likely to do better.

or we fall back to the idea that you pick the good active managers using their past performance. and the evidence is that performance doesn't persist noticeably more than it would if performance were random. of course, there are plenty of funds available with good performance records at any 1 time, because there are thousands of funds in existence, and every year many of the laggards are closed down, and many new funds launched. some of them are bound to do well over 5 years, or 10, or even 20.

So, if you look at markets with less perfect information, you can see funds like Aberdeen Emerging Markets or investment trusts like Templeton Emerging Markets, outpace the average fund over long periods of time. In short periods anything can happen but there are plenty of EM specialists or smallcap specialists which have deserved good reputations because over time their performances have consistently exceeded what 'average' active funds or passive products have achieved.

there will be long-term outperformers - a very, very few of them - even if it's isn't down to skill. picking them retrospectively doesn't help. templeton emerging markets' performance has declined over the last few years. does that show that they lack, or now lack, skill? or will they bounce back? i have no idea.

it might show that emerging markets are no longer inefficient, in the sense which i suspect matters, viz. that the ratio of professionally invested money to amateur invested money is now too high. they were pioneers in emerging markets, so perhaps when they started it was a small amount of institutional money versus a lot of sucker private investors. nowadays, every institutional investor and their dog has an emerging markets allocation.

If the efficient markets hypothesis stood true in all markets there would be no need for active management other than to cater for different risk profiles or return characteristics. In those markets where it doesn't stand true, then clearly there must be a greater case for paying active management fees for generalist investment from a performance perspective too, because of the greater opportunity to beat the market in a resounding way.

i disagee that it matters whether EMH is true. IMHO, it is not 100% true. the point is: can you profit from where it isn't true, after paying the higher costs of active management. the odds are heavily against it.

One could argue that you only get inefficient markets in emerging economies or in thinly traded smaller companies. However, the existence of periodic crashes (e.g. double digit losses in a day in 1987) means that the 'market' is likely not always displaying the 'fair' price of all companies at all times. And an investor like Warren Buffet has built a reputation over half a century of persistent outperformance, in mainstream sectors, which EMH would imply was impossible, though maybe it's just a run of luck like getting heads 45 times out of 50.

inefficiency in that sense doesn't imply that you should use active management. you wouldn't have been protected from (or profited from) the 1987 crash by doing so.

it's arguable that what buffett has done is explicable in EMH terms: see http://www.etf.com/sections/index-investor-corner/21477-swedroe-unpacking-warren-buffetts-genius.html?nopaging=1 ... though that is saying that he put into practice "factor" investing before academics proposed it - which is skilled, however you look at it.

EMH isn't really the point. i agree there are a very few skilled investors. the problem is identifying them in advance.

grey_gym_sock

Linton wrote: »

I am taking a natural income of about 4.5% from my income portfolio. One problem with the Vanguard ETF is that it has a high % of US where dividends are less favoured because of taxation and a low % of Far East where local culture likes dividends. Also small company income is largely ignored. This is a pity as there are useful dividend payers there.

fair points. 4.5% is not crazily high. did you say that includes holdings of individual UK shares? i've no argument against that, if you don't mind the extra effort, and it's reasonably diversified, and you keep trading cost to an absolute minimum.

One of the advantages of using a tracker is that it represents the market. However the UK Dividend "tracker" uses a highly artificial bespoke index specially constructed by FTSE that prevents excess focus on particular sectors and companies that apparently pay very high dividends because their share price has fallen significantly. It is difficult to see what market, if any, this represents.

IMHO, it doesn't especially matter what it "represents". the important points are to keep costs very low (including internal trading costs), diversification high, and that it's transparent how it works.

i think an income portfolio is 1 of the harder things to do passively, though it is possible (and of course you could keep a big cash buffer and take capital gains now and then instead ).

grey_gym_sock

jamesd wrote: »

I don't know of any tracker that has successfully eliminated all of the effect of its charges and costs to allow it to actually match the index performance.

vanguard's (US) total stock market fund has exactly matched its index over 10 years: https://advisors.vanguard.com/VGApp/iip/site/advisor/investments/performance?fundId=0970

as has been said, this doesn't really matter: very nearly matching is good enough.