Active vs. Passive Investing

In recent years one of the most commonly discussed investment topics is whether or not investors are better served by Passive or Active investment strategies. A couple of weeks ago Slade Robertson, from Devon, presented his views at a conference on this issue. Slade was asked to represent the Active side of the debate and we thought our clients would find it useful this month to read some of his views from that conference.

“I recall starting in this industry back in the early 1990’s. It was a great time for investing and in many respects it all felt a lot simpler then, than it does today. The objective of generating strong risk-adjusted returns for our clients has remained a constant but the options available for investors to achieve this goal have certainly become more complex.

My role back then was that of an International Equity Analyst and one of my earliest memories was of being asked to analyse the Japanese market to determine if we should increase our exposure to that region. I was reminded of this a number of years ago while presenting on the topic of ‘Timing the Market vs Time in the Market’.

After three-decades of, what was termed, their ‘Economic Miracle’, excesses were becoming very obvious right across the Japanese system. In the latter stages of the 1980’s this was particularly evident in real estate. The most extraordinary example of this came in the form of the Imperial Palace which is situated in the heart Tokyo. Despite only measuring 3.4 square kilometres it was estimated that in 1989 its value was worth more than all the combined real estate of California! Real estate wasn’t the reference I used when I dealt with the topic of ‘Time in the Market’, it was instead the Nikkei225 Index. In December 1989 the Nikkei225 Index reached a high of 38,950. This was the final leg of a bull market for Japanese stocks that had seen this Index grow six-fold during the prior decade. Ten years later this Index sat at just over 7,000, a decline of over 80%! Even today its value is only 50% of what it was in 1989. This is not some emerging economy that we are talking about here with its violent flows of capital, but rather the largest equity market of the third largest economy in the world. So in answering the challenge of timing vs time-in, I accept that timing investments can be difficult but simply buying that particular index at the wrong time and sticking with it can and has been disastrous. For me there were a number of lessons from my experience here. Firstly, arguments that markets are efficient are often easy to challenge and secondly, price matters!

Today I find myself asking the question, why has this topic of Active versus Passive suddenly become such an important one in today’s world? Why given that the first Index Mutual Fund was established back in 1975 and the first ETF debuted in 1993.

In my opinion there are 2 primary reasons for it: Performance and Fees. And what I want to do today is explore both of these issues and determine whether or not either of these issues are in fact sufficiently problematic for Active Management that investors should give more consideration to Passive solutions.

Firstly on performance. Look the facts are the facts. Over the past eight years, a period of strong equity market performance (in fact the 2^nd longest bull market in equities that we have seen since WWII), and a period where volatility has fallen and asset prices have moved broadly together the average active equity manager, in markets like the US, have underperformed their relevant indexes. I accept this and it is not inconsistent with longer-dated history.

But this is not the case in New Zealand nor, importantly, is it the case for Global Active Equity Funds when we consider longer periods of time. The position taken by many of the advocates of passive investing is to isolate small periods of market performance and look to extrapolate this to sponsor their views. This is dangerous and at times deceptive. When investors are considering which investing styles is best for them it is very important that they consider longer periods of time to base their analysis on, where there have been multiple market cycles. Recently I read through a presentation given by MFS Investment Management where they reviewed the performance of Global Equity Active Managers over a 27-year period, from 1990 to 2016. They broke down this 27-years into individual up and down years for the MSCI World Index. What they identified during this time was that in the 19 positive market years the top quartile Global Equity Active Managers generated alpha (net of all fees) of 6.25% while the median Managers outperformed by 0.52%. In falling markets (8 out of 27 years) the top quartile Managers generated alpha of 7.22% while the median Managers outperformed by 2.68%. In New Zealand the story is similar, as per the Mercer Investment Manager Survey. Over the past 5-years (to 31 March 2017) the median NZX50 Index Focussed Manager has generated a return of 17.4% pa versus the S&P/NZX50 Index which returned 16.9% pa.

There is a bias in much of the pro-passive data that we see presented, to the US market. The depth and liquidity in the US means that the implementation of passive strategies can be done with greater efficiency but this is not a global phenomenon. . There is few better markets in the world to demonstrate this than in New Zealand. The reasonably indiscriminate approach to pricing when passive index related flows come into our market often causes significant disruption to listed company values. This should create opportunities for Active Managers. I like to refer to this effect as an increase in the information advantage for Active Managers because the higher the passive flows, the almost certainly higher the short-term pricing inefficiencies caused.

Now why is this? It is because the relationship between a company’s fundamentals and their share price matter. Ultimately what financial markets are designed to achieve is to create  an environment where companies can raise capital and investors can efficiently allocate capital away from those businesses that face challenges to those that have a future of growth and improvement. Now how on earth could investors accept that the role of active management is dead when the consequence of such a proposition is one that will guarantee investors, in a passive regime, exposure to dying industries, poorly run companies and all those qualities at often the wrong price? When we look back over the history of the New Zealand capital markets we had a number of examples where such a mismatch between fundamentals and value has been obvious.  It is not that long ago that over 35% of the NZX50 Index was made up of Telecom. Today Spark (ex-Telecom) has an index weighting of 8%. The opportunity for Active Managers in the New Zealand market has been to avoid those challenged, over-priced businesses, the Telecoms and Carter Holts’ of this world, and to allocate capital elsewhere. New Zealand is not unique in this experience.

Part of the challenge also facing Passive Index Funds today is fundamentally how the indexes they look to replicate are designed in the first place. Still today the majority of major stock markets are market capitalisation weighted. What this means is that the larger the company, in terms of its market capitalisation, the larger it’s weighting in the index. There have been numerous studies on the challenge this creates which is that portfolios that look to replicate the underlying index will systematically overweight overpriced stocks and underweight cheap stocks. What this means is that with passive index based strategies the largest amount of money will absolutely be committed to the largest and in many cases most expensive companies driving them higher, thus forcing more money into the same opportunity.

With the S&P/NZX50 Index now trading on a P/E multiple greater than 22X, it would seem preferable to me that investors would be better served to have Active Managers setting prices rather than blind passive flows.

The second basis that people argue on in support of passive over active, is fees.

Now the mathematics behind fee drag are obvious. The higher the fees being charged the greater the negative impact on net performance, but there are a couple of observations that I would make here (1) the outperformance of Global Equity Active Managers that I referenced earlier are all net of fees and (2) the cost of passive solutions in many cases are not that dramatically different to active strategies anyway. For example, the NZX’s Smartshares Core New Zealand Equity Trust charges 0.5% as an annual management fee, 0.1% to gain entry to the Fund and 0.1% to exit. Also brokerage is charged within the strategy guaranteeing that if they meet their objective of matching the performance of the underlying index that investors in this strategy will underperform (due to costs). Recently also John Berry from Pathfinder Asset Management wrote an excellent article on comparing the costs of using NZ PIE structured Funds versus some of the ETF’s on offer in the US. As John concluded, when you take into account the tax deductibility of costs within NZ PIE Funds, the impact of capping the tax rate at 28% within a PIE structure and the often hidden costs of custody in US ETF’s the difference between a local Active PIE Fund and a US ETF can be marginal.

My final point today is on ESG considerations (Environmental, Social and Governance). Increasingly we at Devon are seeing a substantial lift in the expectations of our clients to have their funds managed in a way that complies with their concerns over ESG issues. I agree totally with this direction. Not just as a father who wants to see the world as a better place for my children but because I also believe that corporations and investors can play a major role in effecting outcomes in this space.  Passive investing is often unaware of these issues while Active Fund Managers can and do play a major role in channelling funds away from non-ESG-compliant businesses while rewarding those that are proactive and progressive.

In summary, markets won’t go up forever, nor will conditions around volatility and correlations remain where they are forever. This sudden scramble for passive solutions in markets like the US worries me. The level of group acceptance that it has received will create major problems for investors if it continues for much longer at its current rate. I simply don’t think people understand the implications for their investments within a different backdrop. Historically, over time, good Active Managers have outperformed their underlying indexes while the fee argument is fraught with misinterpretation. Clients increasingly need to know that their funds are being looked after with fundamental care and in a socially responsible way. We live in a world today where change is happening at an extraordinary rate and the implications of these disruptive forces will create major challenges for all investors. In such an environment surely those that understand the relationship between fundamentals and price stand a better chance”.