Active vs. Passive. When and Where?

bowlhead99

grey_gym_sock wrote: »

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.

If you look at the ONS stats on UK listed share ownership, of the 47% slice owned domestically (foreign owners not analysed) roughly about a quarter was owned by UK individuals (10.7% of total) and a quarter was owned by unit trusts/oeics (11.3% of total). Once you eliminate the trackers and closet trackers from the unit trust slice you will get a core of active managers who will find plenty of PIs to trade with.

Some of the PI money will of course not really be in free float from month to month (e.g. held by company directors) but over the long term a lot of such shares will become available (when it suits the exiting director's circumstance, not necessarily the optimum time for the director to sell).

Those active managers will also be able to trade with the large institutional owners who may from necessity be restricted in what types of holdings they are able to hold (though I do take the point that they will have 'professional' management too) and certainly an active manager who has free reign to pick whatever shares he likes will have plenty of opportunities to buy most shares because each of the sector specialist active and passive managers (e.g. energy, resources, pharma etc) will only want to buy things from 'their' sector because that's what their own investors asked for.

So, there seems to be plenty of scope for active managers to make 'better' choices and find people to be the losers to allow them to be the long term performance winners. The losers might not even think they are losing if they are happily achieving their own specific objective (capturing a return from a sector or getting dividend income or having a particular volatility profile.)

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.

So I guess a conclusion is, if you don't religiously follow the index, but instead follow various 'factors' such as company size (worth a few percent a year), company valuation in context of its income or assets (worth another few percent a year), fundamental quality characteristics (e.g. profitable, stable, growing, high payout), you can beat the index reliably. But once you 'controlled' for the fact that all he was doing was using a range of techniques to select better companies than the index, and took off the effect of cheap leverage, he would effectively only do as well as the index ('a statistically insignificant annualised 0.1%').

This seems to be quite a good advert for using investment trusts with proven strategies and timely use of leverage, because the real world effect of getting an extra £10 or £10,000 in your pocket is, having that £10 or £10,000 in your pocket. And not "well, I got £10,000 in my pocket but I can fully explain why it was possible and if I 'controlled' for my manager's sound choices I would only get £0 in my pocket, so I might as well have used the index".

Given that nearly all passive products (by value) are simple cap-weighted index funds with and the ones that use formulae to create value tilt, size tilt, quality tilt etc are more expensive and unproven, it is not clear that people should be using the passive products as a matter of course.

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.

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

You're right, what it comes down to is not that an active manager can beat a passive fund when going for overall long term growth - by choosing smaller shares, higher quality shares, more keenly priced shares (most likely to be available in less efficient markets). Of course he can. It is whether the manager will.

If you're smart enough to construct the exact optimum mix of size, value, quality tilt, yourself - out of passive funds created for the purpose - then you can maybe build something better than the index. But most people can't as they are not skilled investment people and may create something worse than the nice cheap hassle-free index. So, they have to either take the index or go through a process to attempt to identify an active fund manager who will do good rather than one who will do bad.

As you suggest, it's difficult to predict which investment managers would do well. But we know that good managers can do well because some of their investing competition are not trying to achieve the same things (needing to deploy more capital or focus on particular sectors), or are PIs who are not as competent, or are professionals who are not as competent, and so a useful 'edge' can be created by a smart manager. So, it is definitely worth looking for them, imho.

If you screen out the persistent poor performers (because poor performance does persist, as per Radiantsoul's link and a variety of other research), you are left with a variety of funds which are not repeated poor performers.

It is then a question whether you can narrow down further when the top funds in a sector change from year to year. In some markets like US largecap where the efficiency of markets leave little to exploit, you will probably have a relatively harder time finding something with a sustainable track record across the cycles that beats the index. Maybe one would be less likely to bother, there. In other markets where there are more inefficiencies to exploit, there will likely be differences in historic performance between those who exploit them well and those who do not, which are not just down to chance.

So, I'll continue to think that active management can be useful and good managers can be found, and you won't. There doesn't seem to be an easy way to meet in the middle here. Obviously we are all agreed that you have to go active where passive funds don't exist, but the question is whether it is even worth using such sectors, or could we do just as well using a single 'total market' index?

I think it is, and not many passive investors use a single index, as if it were a perfect solution, active management wouldn't exist... [I mean, it would be much reduced, as people would wait for a few active managers to set the prices and then just pay the market prices for the market proportions.]

Jamesd's example of 'global growth' sector makes sense as something that could be addressed with active management. The world is a big place. How do you split your money across the global markets? Just on country market cap doesn't make much sense if you are looking for particular types of companies and not just the biggest companies in each region, with 'value' and 'size' influencing factors on returns ; and a consideration of whether and where you can get an 'edge' over the PIs and dog funds.

The split between countries, emerging vs developed etc and focus on what types of companies and what markets, is something that you are going to need to take judgements on or pay someone for their judgement. The gulf between returns of country A,B,C,D etc up to ZZZ will be significant and dwarf annual management fees of 0.2% or 0.8%. So the question is, can a professional fund manager come up with country and sector selection as well as individual stock selection, better than an index to make the fees worth it. Logic would dictate that they could, if logic has already said that Warren Buffet can make his premiums with simple techniques overlaid on top of the index, and a research team to consider market direction and momentum and the value opportunity, rather than slavishly following the index.

So it just comes down to whether someone is able to 'prove themselves' at making good investment choices and whether if he made them in the past he could make them again in the future - certainly the economic landscape is different today from what it was 10 or 20 years ago; we find ourselves on new ground each month with one global or local issue after another. My contention is that someone is able to be a 'good' manager and also that it's possible for that person's fee to be 'affordable' to the extent it doesn't wipe out the benefits of the extra performance his ability creates (whether you judge performance as outright growth, or delivery on a targeted objective like volatility or income etc). And that it is possible to find that person.

But taking the index is certainly an easier life than spending time, effort, money in pursuit of that good manager, so if the benefits are not easily provable or quantifiable I can completely understand why many people would just take the index.

Mistermeaner

My s+s portfolio (excludes pension) which is a very small part of my overall wealth is split roughly into equal shares (present values and monthly purchases) between the following funds:

- vls 80
- l+g multi 5
- woodford equity income

Accepting the decision to split it this way is an active decision by me, removing that from the assessment how active vs passive would you say the underlying allocation is?

I would think 50:50 maybe (woodford 100% active, vls 100% passive, l+g 50/50)?

What I think I struggle with is I think what actually defines 'passive' surely a true passive portfolio would simply hold EVERYTHING that is investable in the whole world in the exact cap weighted ratios that they represent.

Anything that deviates from this is surely active so eg if you chose to use trackers for the developed world but active for emerging then you have made an active decision regards the weighting in each and have therefore made the whole portfolio active?

Isn't it a bit of a moot debate?

bowlhead99

ggb1979 wrote: »

What I think I struggle with is I think what actually defines 'passive' surely a true passive portfolio would simply hold EVERYTHING that is investable in the whole world in the exact cap weighted ratios that they represent.

Not really, imho. It is very unlikely that a UK individual investor would allocate an entire portfolio in the same way that the 'average' investor on the planet would allocate their own assets. That would give them a very heavy bond allocation (both corporate and global government) and a light equities allocation. Because there is simply more total value of corporate (banks and insurers and nonfinancials) or government (national or local) bonds or debt instruments in issue, than there are equities instruments.

So when someone thinks active vs passive it would be garbage to say that 'passive' means that the actual allocation of asset classes have to be based on what financial instruments had been created for the entire planet to use, because most of those financial instruments were not created with you in mind and are not particularly suitable for meeting your needs. There has to be some assessment, from you or your adviser or your fund manager, of what types of assets might be suitable for meeting those needs or objectives.

For example, if your goal is simply to create the highest long term 'growth' in your wealth, it is unlikely to be suitable to have two parts bonds to one part fixed interest secured and unsecured loans to one part equities, as the total population of individual and corporate and government investors might hold 'on average'. Because logic (and the last century of history) tells us that uncapped growth from equities should outperform the lower risk, fixed returns from loans and bonds.

Also there are things like 'home country bias' which might be naturally seen in UK and most other countries, as despite the lure of the global markets, most investors will still want a healthy chunk invested closer to home in their local currency - which can be cheaper and lower risk than seeking the full set of global opportunities even though it is of course an active choice to target that particular profile.

So what we are on about with the 'active vs passive debate' is not necessarily the high level asset class choices, but how you deploy the money after you have made your choice. People will then use a variety of techniques and strategies to do the deployment; passive indexing is one strategy, active is all the others. Though to be fair, there are more than one type of index emerging for passive funds to follow these days, beyond the obvious market-cap ones which take 99% of the money.

Passive is cheap; there seems no point paying a manager to hold Tesco and then diversifying to pay a second manager to hold Sainsbury when you could use a total market index that holds both, and avoid both the sets of management fees. The question is just whether you are happy with the 'eggs in one basket' exposure that gives you, of holding over 3x the Tesco vs Sainsburys, which seems a lot, until you realise you have 100x in Apple vs the Sainsburys...

The prices of each might be 'fair' but it could be a funny allocation if your intention was to have a broad allocation to the opportunity set of each country and industry. And if the prices were not necessarily 'fair' because the market isn't always fair sometimes, you might be very nervous about making those very large allocations or relatively very small allocations amongst opportunities if you hadn't reviewed (or paid someone to review) the financial strength of all the organisations.

To passively assume that 'the market' has made the determination and the price is fair and the weighting will suit your needs, could feel like a leap of faith, but it does save costs. The reason people sometimes don't take the leap is that they are not convinced that an exclusive focus on cost is going to suit them, because cost is only one of the parts of their net return, the other being gross return. It is however a part that you can easily see and feel you are controlling, unlike the gross return itself.

Anything that deviates from this is surely active so eg if you chose to use trackers for the developed world but active for emerging then you have made an active decision regards the weighting in each and have therefore made the whole portfolio active?

Effectively, yes if you use some active funds in some areas then you must by definition be an active investor. It doesn't follow that it 'taints' the part of the portfolio which is merrily going along being passively invested cheaply.

It does of course mean that your active brain might need to work overtime to refine the active fund choices to avoid excessive overlap; if you trust your global portfolio to a single global multi-asset fund or fund-of-funds manager, then active choices will be made by the manager which endeavour to avoid duplication and missed sectors in line with the strategic goal - but if you are running multiple independent funds like an active 'global equity' fund alongside a US tracker fund you might be very overweight in certain places because the active manager you employed for the global fund doesn't know you've already got a large market-cap-based allocation to USA. This is of course the case with any portfolio where you use more than one fund and DIY.

The question that remains is, if the market is efficient and trackers are a cheap useful way of getting a fair return from a market, and I have sorted my equity/bond split to the level I would like, and maybe within equities I have sorted out my UK and ex-UK split, why would I not just get a UK equity tracker and an ex-UK equity tracker? Why bother at all with individual countries and these periphery markets and specialist sectors and company size-ranges which are under-served by trackers? What's wrong with having most of my money in the countries and business sectors with the most money allocated to them by other people, and just holding an all-world tracker with exposure to the biggest 4000 companies?

Well, the answer is the same reason why you didn't allocate 75% to loans and bonds and 25% equities. What is right for 'everyone, on average' to hold does not necessarily meet your needs. If growth is higher in emerging markets or frontier markets or smaller companies, and your goal is growth, you might want more of them than some other kind of investor wants. So, even passive investors might make active choices to select their asset classes and sectors and types. But others might just use All-World ex-uk and FTSE Allshare and be done with it, because they don't think they can reliably better it.

Basically you go from asset class allocation (shares bonds real estate etc) to sub-sector or sub-class allocation (in terms of industry or region or size characteristics or growth/income characteristics or something else) to individual stocks. Some people will do everything themselves and take the very active choice to hold individual stocks themselves for even less money than an index fund. Some will pay to outsource all 3 layers.

Some will do their own asset class and sector allocation, and then having decided they just want to get the money into a sector will use an index as the very cheapest way of doing that last stage; they are not concerned about company-level allocations because it can cost half a percent to make those allocations without guarantee of success.

What is perhaps curious is that if you can trust the market to allocate your cash properly between Tesco and Sainsbury, or Exxon and Chevron, or Shell and BP, or VW and BMW, Apple and IBM in individual markets, when those companies could have different return characteristics... why could you not trust the market to allocate across sectors, what was the point of doing the sector allocation yourself? And why does the argument at 'asset class level' of "don't follow the market to invest in something just because it exists in large quantities" not also apply to company level in terms of piling into Apple shares?

The explanation is probably that making a high level asset allocation decision might seem easy because they don't involve 10000 choices, just an infinitely variable split between a few choices. Making rough sector allocations within equities or bonds might also seem easy because they don't involve 10000 choices, just an infinitely variable split between a few choices.

But once you get to company level you have an infinitely variable split between 10000 choices. That is going to be prohibitively difficult to do yourself, so you have to outsource it for half a percent a year or let the computer pick.

Letting the computer pick based on what other people in the market have picked, is a shortcut and clearly saves money, so if you're not convinced by why you should spend time and effort searching for the manager who is worth his half a percent a year, perhaps without success, you might just choose to give the money to the index funds and tell them to get on with it, and call yourself a passive investor, even though you will actively choose the passive funds and the proportions in which you allocate them capital.

Isn't it a bit of a moot debate?

The 'active versus passive debate' will run and run. It comes up every few weeks here although sometimes you have to wait several months to get the really long posts that explain the arguments. A very popular comment would be 'not wishing to re-hash the active vs passive debate but...' or 'of course there is an active vs passive debate which has been done to death' I remember there was quite a bit on the long 'vanguard lifestrategy' thread (an inpenetrably long thread that went on for tens of pages before newer one was started). And of course you can see various forum regulars talking about it on the thread from a decade ago that jamesd linked above.

There will always be people who are passive investors who acknowledge the merits of active funds for certain situations or understand why an index fund does not exist in a certain market or would be a poor quality index if it did. And likewise there will always be people who are generally active investors who recognise that cheap broad access to some markets can be handy. For one side to cling to a 'faith' like a religion that they deem infallible, would make it difficult for them to be taken seriously.

I think most people will acknowledge the strategies of others to be perfectly valid - just that whatever they picked is more valid than others, because otherwise they are admitting they could have picked better!

For further reading I made quite a flippant post earlier this month which you might find entertaining, which also had a graph of the market caps of some asset classes globally (though didn't include the $trillions in property, for example).
https://forums.moneysavingexpert.com/discussion/comment/68366932#Comment_68366932

That one doesn't really further the debate but if you search 'active vs passive' on the forum or on the internet generally you will find plenty of background reading, including research papers and the debunking of them. If, in the interests of avoiding bias, you ignore everything produced by someone who has a view or a financial interest one way or another, you will find your search more limited - and a further problem is that you can't really trust anyone or anything you read on the internet

badger09

bowlhead99 wrote: »

If, in the interests of avoiding bias, you ignore everything produced by someone who has a view or a financial interest one way or another, you will find your search more limited

:T

bowlhead99 wrote: »

- and a further problem is that you can't really trust anyone or anything you read on the internet

Not even you? :eek::eek::eek:

bowlhead99

badger09 wrote: »

Not even you? :eek::eek::eek:

Yeah, pretty much everything I say can be taken with a pinch of salt, as it's just one person's view in a sea of many.

Hopefully most of it makes sense to those reading it (especially those with more experience than me) but no advice should be inferred, no warranties implied or guarantees given. Cross check your sources etc.

As a side note, I remember when I got to some previous 'milestone' amount of posts I said I was going to take a break from posting for a while, perhaps indefinitely, as some of what I was writing was getting a bit samey and it was eating a lot of time. I lasted about a week before I broke when looking in at the forum in a spare moment and someone said something that didn't, to me, seem correct, and I had to barge back in to the fray.

I'm going to try a bit harder now I've logged 3000 posts which represents an insane amount of PC / phone / tablet screen time. Seems a good milestone to take a hiatus and do more outdoorsy stuff for the summer. So, I'll either be back in a week like last time, or maybe it will be September or beyond.

Have a good summer, all y'all, and just in case:
:xmassign:

In_For_A_Penny_2

bowlhead99 wrote: »

Seems a good milestone to take a hiatus and do more outdoorsy stuff for the summer. So, I'll either be back in a week like last time, or maybe it will be September or beyond.

Have a good summer, all y'all, and just in case:
:xmassign:

You will be sorely missed though I doubt anyone would begrudge you some sunshine. . . Enjoy!

badger09

@bowlhead99

I do understand what you're saying about the 'insane' amount of screen time you've devoted to the forum, and hope you enjoy your summer break. I will miss you though:o

If I were a betting badger, which I'm not , I'd wager you won't be able to stay away until September :beer: