Brian Tora takes a personal look at the ongoing investment debate between these two different investment styles and explains why active management still has a place in his investment portfolio.
I have a friend who is a serious investor. Having been an investment analyst for one of the major American investment banks, he is now semi-retired and confines his business activities to training a new generation of investment analysts on a self-employed basis. This is so he can concentrate more on running his own not insubstantial share portfolio. What is interesting about his approach is that he is an active investor, investing directly in the shares of companies he has rigorously researched himself, yet if you ask him for advice on where to invest, he will unfailingly direct you to index linked funds.
The “passive” debate
His reasoning is simple. Unless you have the ability and commitment to undertake in depth research into companies, you are better off taking the passive approach on the basis that more fund managers underperform the market averages than succeed in beating them. Sadly the statistics support this contention, though it is hardly surprising that they do. Markets are a zero-sum game for investors. For every fund manager who outperforms the index, another must fail to beat it. Moreover, indices do not suffer costs, whereas funds do, so the dice is weighted against the investor.
Markets are a zero-sum game for investors. For every fund manager who outperforms the index, another must fail to beat it.
That said, most investors are prepared to adopt an active stance in an effort to stay ahead in the game, despite clear evidence that many will fail to do so. True, passive investing is becoming increasingly popular, particularly amongst pension funds where the lower charges applied to these funds add to their attraction. But the growth of this approach to investing carries its own set of challenges.
Computers are playing an increasingly important role in the investment management sector. Aside from the way in which technology makes simple the task of running a passive investment vehicle, algorithms exist that seek to profit from the changes that become necessary when an index undergoes constituent changes. As Exchange Traded Funds (ETFs) started to develop, traders in investment banks sought to arbitrage between the cash and derivatives markets in order to exploit anomalies. Interestingly, I was told by a senior executive at one of the larger ETF operators that traders at Lehman Brothers – the bank that triggered the financial crisis of 2008 when it collapsed – were amongst the best at profiting from such anomalies.
A rise in volatility
Today passive investing is truly a massive business and the use of technology in managing investments has become far more sophisticated. This can, of course, add to volatility as events that trigger a change in underlying portfolios could result in very large buy or sell orders being placed in the market by a wide variety of operators. While the last quarter of 2018 did see an increase in volatility, the first quarter of 2019 has been remarkably calm, given the very significant events that have been taking place around the world.
One possible outcome of the concentration of investment power into passive vehicles could be the condensation of market cycles. In other words, bull and bear phases take place more swiftly than has been the case in the past. This is a situation that could allow nimble active managers to benefit, but spotting who the winners and losers might be in the active universe is no easy task. Moreover, success in the active field can lead to massive investment inflows, which in turn can change the dynamics of the fund being managed.
An active approach can deliver
So, in some measure taking the passive investment route can be considered as an opt out from trying to stay abreast of the active scene. However, there are managers who have delivered consistent long term outperformance. The emphasis must be on long term, though, as even the best of active managers will be caught on the wrong foot from time to time. Perhaps the best medium for judging the long term strength of individual managers lies in the closed-ended market. Investment trusts are, after all, unlikely to see portfolio performance impacted by inflows or outflows.
Personally I favour a mix of investment trusts and open-ended funds in my portfolio. Aside from anything else, there are some asset classes better suited to be managed within a closed-ended environment – like property and private equity. Indeed, some areas have more limited passive options, though these days you can index just about anything. And if diversification remains the principal risk management tool for portfolio compilers, it makes sense to include as wide a range of asset classes as is appropriate for the underlying client.
Active and passive
There is no reason not to adopt both active and passive approaches in a portfolio. Some strategies are based precisely on such methodology, with often a core/ satellite portfolio construction being adopted. Other management techniques include using index funds as a temporary measure to gain exposure to a particular market or asset class until a suitable active fund is identified. I have nothing against either approach, but cannot help feeling it will be a more difficult environment for investors if active management is squeezed into the margins of investing. I plan to continue to fly the active flag and hope that by careful research and rigorous monitoring I can stay ahead of the game.
Brian Tora is a consultant to investment managers,