Question to passive investors - does it really return?

dllive

Hi all,
Ive been following http://monevator.com/ for sometime. I havnt acted on anything he's said about passive investing.

I really like the 'set and forget' ethos - but I cant get it in my head how passive tracker can beat actively funds such as Invesco Perpetual High Income etc... Im sure a lot of active fund dont beat the index, but some do, and its not that hard to find them (I look for funds that have beaten the index in the past - and they tend to continue to beat the index becuase the managers know what theyre doing... I presume!).

Even after their fees, they still beat the index.

Am I wrong? I probably am as Im not immersed in the investing world. Does anyone have any charts showing how passive indexes beat the active funds?

Thanks

Malthusian

(I look for funds that have beaten the index in the past - and they tend to continue to beat the index becuase the managers know what theyre doing... I presume!).

I'm afraid you presume wrong. There is no evidence that any one fund manager will consistently beat the index in the future.

Of course it is trivial to find fund managers who have beaten the index in the past. There are thousands of fund managers in the world and it is a statistical inevitability that many of them will have beaten the index, and a small minority of those will have beaten the index over a sustained period of time. There is however no evidence that this means they will continue to beat the index in the future.

It is the same as how it is very easy for me to tell you what the Lottery numbers are on Saturday 7th May, but very difficult for me to tell you what they will be on the 14th.

Consequently, increasing numbers of people prefer the certainty of higher returns that comes from reducing costs - as passive investing does.

It is not much of an achievement to beat the index "even after fees". As long as your annual fee is less than twice your fund's beta you have just under a 50-50 chance of outperforming by more than your fee.

dunstonh

I really like the 'set and forget' ethos - but I cant get it in my head how passive tracker can beat actively funds such as Invesco Perpetual High Income etc...

Some managed funds beat trackers. some dont. Some investment areas dont have trackers. Some do. Some investment areas really suit trackers. Some dont. I read an article recently (and havent validated the information to check it) but it said that the majority of managed US equity funds underperform whereas the majority of managed UK equity funds outperform. So, when building a portfolio, it is important to keep an open mind and pick from the best of both. However, some people are managed biased and some are tracker biased.

One thing you often find is that index tracking funds are built to track the index. Whereas managed funds are built to follow an investment strategy. So, whilst they may sit in the same sector, they have a very different approach to investing. Some managed funds may take a low risk approach and others take a high risk approach. So, comparing is not always simple.

The important thing is that you do not know the future in advance. You wont know if the next x period will suit tracker or managed. You select the strategy and take the good and the bad that goes with that strategy. Although some managed funds do have strategies that work better in certain periods of the economic cycle and not other parts. So, if you go managed, you do really need to keep a closer eye on it than you would with trackers.

nb0825

Active funds are inherently more risky because these funds are trying to beat the market whereas passive funds merely track gains and losses in the index. If the stock market is up, active funds will give better returns but if the stock market is down, active funds will be greater losses. Obviously, if you time it right and pull out the fund during gains, then great, but who knows.

BLB53

In his book 'Smarter Investing' Tim Hale uses the analogy that we all like to think we are a better than average driver - but not everyone can be better than average. Human nature drives us to compete with others, to succeed, and to be better than average. Investors try to get a better than average return and often select funds which promise to provide this.

However, the markets are very efficient. All the empirical evidence over decades shows that beating the market consistently after costs through skill is very difficult. The fund managers who can do this are rare and are very difficult to identify in advance.

It is a mathematical certainty that the market will beat the average fund manager after costs.

The market is a zero sum game - leaving aside costs, for every investor who gains there is another who loses. Active fund managers account for around 90% of the market so a fair number of losers will come from this group.

Index funds will beat the majority of managed funds due to their lower costs - this is simple maths.

Here's an interesting article (US focus) with a few charts which may help
http://awealthofcommonsense.com/2015/12/uncle-sam-hates-active-management/

If you like 'fire and forget' you could do a lot worse than Vanguard LifeStrategy.

Linton

It depends on the sector. For the major US indexes (eg S&P500) where almost all research data comes from then it does seem that beating the index is difficult. However elsewhere the situation is far less clear. In particular, beating the FTSE100 seems fairly easy. In various niche sectors index funds do badly or may be non-existant.

Contrary to what has been said managed funds are not inherently riskier than index funds. Indeed one would expect the reverse to be true in that some managed funds have an aim of reducing risk possibly at a cost of a lower return.

BLB53

In particular, beating the FTSE100 seems fairly easy.

I am fairly sure this cannot be the case. According to the latest SPIVA scorecard only 3 out of 10 managed funds outperformed the market over the past 10 yrs.

http://us.spindices.com/documents/spiva/spiva-europe-mid-year-2015.pdf

Better than The Netherlands though where 0 out of 10 managers outperformed the index!

colsten

dllive wrote: »

Ive been following http://monevator.com/ for sometime.

There's lots of good discussion on active v. passive on the very site
http://monevator.com/SearchResults/?q=active%20versus%20passive

grey_gym_sock

BLB53 wrote: »

In his book 'Smarter Investing' Tim Hale uses the analogy that we all like to think we are a better than average driver - but not everyone can be better than average.

in a few years, we'll get posts on MSE from people asking why they should use the self-driving facility on their car, when they know that they are better drivers than average. perhaps insurers will have started treating drivers as being "at fault" when they've failed to use self-driving; the statistics may show that it's safer to use it, but isn't this discrimination against the more talented drivers?

bowlhead99

nb0825 wrote: »

Active funds are inherently more risky because these funds are trying to beat the market whereas passive funds merely track gains and losses in the index. If the stock market is down, active funds will be greater losses.

That doesn't follow. Some managers (many managers) have the goal of investing with lower volatility, or preservation of capital as an objective, or deliberately seeking income rather than maximum growth even in a very bullish period, so will not grow as aggressively when markets are going up.

And when markets are going down over a long bear cycle, managers of small funds have the opportunity to switch sectors to those less likely to be affected by the downturn while the tracker manager does not have any choice but to hold banks through the credit crunch and overvalued dotcoms week after week through the bursting of the tech bubble as they gradually become less overvalued, losing the owners their shirts.

Managed funds with massive portfolios may not be able to do that so effectively because of a lack of liquidity in certain companies that they would have otherwise liked; and some would have a remit not to stray too far from a certain sector allocation set out in their prospectus or dictated by their main investor, so some managed funds can prosper at the expense of the less flexible ones.

That's not to say managed funds always get it right, of course. Just that managed is not inherently going to give you a more volatile ride as you imply.

Of course, a fan of passive investing will say that holding anything other than the "market basket" in the proportions of their market capitalisations is taking on extra risk, so if you do that and don't lose as much as the index, your success was only due to taking on more risk.

But that comes down to definition or interpretation of risk, which can be personal. I may feel I shouldn't massively skew my supermarket sector investments to Tesco over Sainsbury and Morrison's - and an active fund manager might agree and split the money equally among all three to avoid having eggs in one basket, as he is only trying to deploy £50m across 100 opportunities and is not constrained by liquidity because all of the companies are worth billions.

The tracker manager says splitting the money equally is very risky because the market says Tesco deserves much more of your money than the other two put together (because it has more stores and therefore more shares in issue and you must follow the opportunities by their relative size).

BananaRepublic

The first paragraph in dunstonh's post is significant. The US and UK/European markets are very different, for reasons I do not understand. Much writing on investment is from Americans hence the emphasis on trackers. In addition, if a large proportion of the shares in an index are held in index funds, that will undoubtedly have an impact on the behaviour of the index.

When I look at my investments over the past 25 years, in all but one case my active funds far outperformed my passive funds, after costs. And that is why I no longer hold any passive funds. The one bad active fund was a dog, the first PEP I ever bought, and I did not do my research, listening instead to the marketing carp. I sold that fund after a few years, and the replacement soared in comparison. Some of my active funds have returned superb results, others have been good, and I wish I could know beforehand which would do best!

It is true that in the UK market, as an example, many if not more than half of all managed trusts underperform the index, over the long term, 5 years perhaps. Many people take that to indicate that active funds are overpriced failures. In truth if you look deeper at the good funds, and there are many funds that consistently beat the market, then do some basic statistical analysis (Bayesian statistics), you will see that the probability of such long term overperformance being by chance is very very low. In fact it is so low as to be improbable. Or in other words, there are some funds whose performance cannot reasonably be explained by mere luck. My belief is that there is a small number of highly talented fund managers who more than earn their high fees. And conversely, many if not most do not earn their fees. The question then is can you choose a good fund, and if so, how. My method is simply to use long term past performance relative to the index. I avoid new funds from star managers, and old funds from bad managers. I also look for consistent good performance, with no short term huge gains, as that can make it look like the funds did well each year, rather than benefiting from one very lucky year and lots of mediocre years. In other words, the funds must consistently beat the index over 5 years, or preferably 10 years, with very few years of underperformance if any. Is this the best approach? Dunno, but it has worked, and I hope it will continue to work, but I have no proof that it will. Of course you should diversify and not trust one manager, who might have popped his cherry, and underperform in the future. After all, it is conceivable that a manager follows a strategy for 5 years, gets stellar returns, but then the underlying reason for the success of that strategy disappears, and the fund tanks. That is one reason I avoid trendy areas, where the sector is propelled by momentum from a bubble, which will eventually burst.

Incidentally there are some advanced trackers, which try to avoid the pitfalls of the tracker, whilst keeping the low costs. The problem with the standard tracker is that you end up buying huge amounts of a company as soon as it enters the index - FTSE 100 say - and then selling huge amounts as it exits. I am sure someone can point you towards these variants on the tracker theme. I cannot even remember the name of the technique they use.

I suspect investming will change over the next 10 years. Already we have access to free tools that I would have loved to have 25 years ago.