The battle between active and passive managers

Behind the scenes of Australia’s fund management industry, active and passive managers are slogging
it out for bragging rights over which investment strategy will prevail.

Active managers principally rely upon stock picking and market timing in order to outperform a nominated benchmark, while passive managers typically take a ‘buy
and hold’ approach and aim to replicate a market index.

The performance of a benchmark or index is commonly known as beta and
the outperformance generated over and above an index is referred to as alpha –
active managers like to refer to alpha as ‘manager skill’.

If you believe in the investment adages that diversification is good and that it’s time in the market not timing the market, then you are likely to support the index manager. If you believe in the notion that fund managers are able to add value by picking and choosing the best stocks as well as when to buy and sell them, then you are an active manager supporter.

Timing is everything

According to active managers, we are currently in a ‘stock pickers market’. After experiencing 17 months of falling stock prices, many active managers believe that
the market has been overly beaten and there is value to be had in picking the right stocks.

As an investor trying to decide which strategy is most relevant, it’s important to remember that active managers still rely upon beta to create the market momentum necessary for them to trade, to facilitate mispricing and to create trading opportunities. Conversely, index managers also need the active managers to keep the market efficient.

After close to 18 months of poor performance by the Australian equities market, many investors are left questioning whether active Australian equity managers have actually added any value at all. Did they outperform the index? Have they earned their fees, and if not, why not? More importantly, why pay more in fees for active management and receive less performance?

Investor confidence is a funny thing
and at least 80% of investors generally believe that they can achieve above
average performance, but by definition, at least 30% have to be wrong. So it’s no wonder that investors continue to believe
that active managers will outperform, especially in bear markets.

However, according to the Standard & Poor’s Indices Versus Active Funds Scorecard, over a five year period to the end of 2008, the S&P500, S&P MidCap 400 and S&P Small Cap 600 indexes all outperformed active fund managers by 72%, 79% and 85% respectively.

So why invest passively via an index manager?

The most popular reason is fees. Index managers generally charge significantly less in management fees than active managers. For example, an investor will pay 0.34% pa in management fees to invest in the wholesale Vanguard Australian Shares Index Fund compared to 0.79% for the BT Wholesale Core Australian Share Fund, with both funds managing to the S&P/ASX 300 index. Of course, if active managers truly believed in their ability to consistently deliver alpha, then they would only charge performance fees.

Some investors also prefer index managers because they tend to be more consistent in the application of their investment strategy. Their mandate is clear, replicate the index.
 By comparison, active fund managers are paid and rewarded by their ability to outperform the index. As a result, they adopt additional risk in order to attempt to achieve a greater return.

The pursuit of additional return could also be attributed to why the performance of active managers is typically more volatile than passive managers. According to research from Vanguard, there is only a 19% chance that an active manager that was the top performer last year will again top the performance chart the following year – proving that consistently outperforming the market is actually more difficult than most investors think. If you accept the fact that the majority of portfolio performance actually comes from asset allocation, then the role of an active manager becomes relatively limited. Where active management does make sense is as a specialist satellite allocation to a core index manager. Working on the basis that the market generally has access (and reacts) to the same information, then the majority of performance is actually beta, not alpha.

Then again, if you never invest in an active manager, you will never give yourself the opportunity to outperform the market.

Alpha is definitely worth paying for, the key is finding the right manager that will deliver you the specialist investment approach required to complement your passive allocation.

For investors that want to steer clear of allocations to tobacco companies and weapons manufacturing, index managers often don’t provide investors with ethical, socially responsible or sustainable screening strategies. So if you are looking for these strategies, you would be best served considering a specialist active manager.

If you’ve got the time and the inclination, then get your beta exposure from a passive manager and your alpha from specialist. Most importantly, make sure that you get what you pay for. Compare the fees payable for active management and review their performance history to ensure they are consistently outperforming their stated benchmark. If they’re not adding value, then don’t invest in them.