Learn to Trade the Markets : Part 5 (of 6) Active or Passive?

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“…Look at the performance of the stocks you have picked yourself, and any active funds you’ve chosen. Compare it against that of the index of the market in which they are listed. Can you say, truthfully, that your selections have beaten that benchmark?…”


In this fifth in a series of six articles, we look at how you can look to trade the Markets, be it full time, part time or occasionally.

Every one reading  these articles will be at a different level compared to the next man. Fundamentally the rules are the same. Over 80% of retail “punters” lose money. Hopefully, here, we will try and help you be in the 20% that doesn’t.

We will cover different strategies, ideas, entry and exit plans and try and get you to just think a little more before giving your hard earned cash away. There is no right and wrong way to make money in the markets. Find a strategy that works for you.

The markets have been around for centuries, they are not going anywhere so take your time with your research. There is a plethora of information around these days with the advent of social media and the internet, use it. Ensure you have an exit plan. Any fool can buy a share, the trick is selling higher than you bought. We hope you find some benefit in one or some of the articles. The fifth article here features another very important topic : Active or Passive?

“…Broadly, funds fall into two categories: active and passive. Active funds are overseen by professional fund managers who pick stocks with the aim of beating a market’s benchmark index. Passive funds simply track an index or market sector, allowing the investor to benefit from its overall performance…”


Most TMS readers will want to dedicate at least part of their portfolio to individual stocks. It’s the volatility of individual equities, particularly small caps, that opens the possibilities of making significant short-term gains from investing. This series has tried to emphasise tried and trusted risk management techniques that allow you to hold on to the capital you need to take those educated risks.

But if you don’t do so already, you should also consider investing in funds as well as individual stocks. Stakes in some well chosen funds can ensure a good proportion of your portfolio provides long term, compounding returns, allowing you to devote part of it to pursuing shorter term advantage.

Broadly, funds fall into two categories: active and passive. Active funds are overseen by professional fund managers who pick stocks with the aim of beating a market’s benchmark index. Passive funds simply track an index or market sector, allowing the investor to benefit from its overall performance. This article looks at the fierce debate between advocates of each approach.

The case for passive funds


The case for passive investment begins with a simple, direct question. Look at the performance of the stocks you have picked yourself, and any active funds you’ve chosen. And compare it against that of the index of the market in which they are listed. Can you say, truthfully, that your selections have beaten that benchmark? They might have done so over a year, perhaps for two. But have they outperformed over five years? Or over 10? If they have you are doing better than the great majority of highly paid professional fund managers.

One of the better known stories in investment’s recent history is Warren Buffet’s million dollar wager with the US advisory firm Protégé Partners that the world’s best fund managers could not outperform the S&P 500 over a decade. Sure enough, when, in 2018, those 10 years were up, the Partners’ hand-picked ‘fund of funds’ had failed to beat a humble US equity tracker. Buffet has since said that were he to pass his accumulated billions to an ordinary investor he would recommend they just put it in a cheap S&P 500 index fund and let it slowly accumulate with the fortunes of the market.

Advocates for passive investment argue that the most secure way for investors to build wealth is simply to track a basket of market indices, or even just the global index, rather than picking their own stocks or paying the unjustifiable fees commanded by a professional manager.

 The efficient market hypothesis


The intellectual case for holding index funds derives from the ‘efficient market hypothesis’, the theory that trying to beat the market by picking stocks is usually a futile exercise because share prices in developed markets reflect all available past and present information that might impact the price, ensuring the market is already and always efficiently priced. Because they always trade at their fair value, it is impossible to consistently outperform the overall market by picking stocks.

It’s a variant of an argument about market efficiency that ran through 20th economics, most famously associated with the economist Friedrich Hayek who argued against advocates of economic planning on the grounds that nobody can be sure of having so much information that they can do a better job of allocating resources than the market. His critique was levelled at Soviet economic policy, but it also applies to stock-pickers. A powerful little paper by another Nobel prize-winner, Bill Sharpe, The Arithmetic of Active Management, argues that the aggregate performance of all active managers for a given index always and necessarily equates to the index itself – minus the fees they charge. One fund might have some success for a while, but over the longer term their collective performance will converge with that of the index itself.

Research by companies like Morningstar and S&P, such as the regular SPIVA study, shows that for the most part, the majority of fund managers in developed markets do indeed fail to beat their benchmark over both short and longer-term time periods. The percentage of funds beating an index may fluctuate from year to year, but no active fund category beats the market more often than not over a 10-year period.

Because it is impossible to identify a successful fund in advance, the humble strategy of simply tracking an index makes sure investors get whatever upside it produces. Fascinating research conducted by Hendrik Bessembinder, an academic at Arizona State University, on historic stock market returns in the US, shows that the entire gain of the market since 1926 is attributable to the best performing 4pc of listed companies. The only way to ensure you get access to those gains is to buy the entire market through a tracker.

The universe of exchange-traded funds


As doubts about the ability of fund managers to beat benchmarks among disillusioned investors has increased, index funds have become ever more popular. A study last October found they accounted for nearly a fifth of the money saved in open-ended funds by UK investors, up from 6.6pc 10 years ago.

The passive funds market has developed into a vast industry since the first tracker – the Vanguard First Index Investment Trust which simply tracked the S&P 500 – appeared in the 1970s. Investors can now choose from a constellation of exchange-traded funds (ETFs) offering access to every index and economic sector. Whereas an active fund seeks to outperform an index by overweighting or underweighting particular securities in that index or by holding non-index securities, an ETF simply aims to deliver the same returns as the index by holding the same securities as the index in the same proportion. It can represent a basket of equities such as the FTSE 100 index, a basket of bonds such as the FTSE Actuaries UK Conventional Gilts All Stocks index, or track a particular market sector.

Themed ETFs following sectors such as mining, oil and gas, clean energy, technology, and health have become ever more popular, and increasingly niche, some the most fashionable offering exposure to the emerging space, hydrogen, and medical cannabis industries. Indices can represent a basket of securities weighted by their market caps, or be ‘equally weighted’, giving greater exposure to smaller companies within a market.

In all cases the approach is transparent. ETFs are codified using a publicly available set of rules specifying how securities are selected and weighted and how frequently that process is refreshed. Their risk-return profiles, therefore, are directly linked to the risk-return profile of the indices they track. ETFs tracking emerging-market equity indices, for example, are more volatile than those tracking developed-market indices.

ETFs are highly liquid, being tradable throughout the day like regular equities. And because they require little or indeed any day-to-day management, they tend to have much lower fees than active funds. Whereas the average fee for an active fund available to UK investors is about 0.85pc per year, the average fee for a passive fund is around 0.23pc, with ETFs tracking major market indices, such as the FTSE 100 or S&P 500, charging less than 0.1pc. This makes them very attractive for long term investors, mitigating the notorious issue of fee compounding.

Interactive Investor writer Tom Bailey offers a vivid illustration of how investment fees can impact long term returns. Say you have invested £100,000. If it earns 5pc every year for the next 30 years, you would make about £432,190. If your money was invested in an active fund, charging 0.85pc a year, you would have to pay £93,519 in fees, reducing your pot to £338,671. If your investment was in an ETF with a fee of 0.23pc, your pot would be worth £404,674. That’s a difference of £66,003.

The case for active funds


The compelling logic of the case for passive investment, backed by substantial evidence, continues to win new converts. But for others it’s just too neat. Are the results achieved by successful funds, and indeed private investors, just down to luck? There are good reasons to think there’s more to it than that.

For one thing, the intellectual and financial firepower available to investment houses gives them opportunities to access informationally inefficient markets that passives can fail, or are unable, to unlock. Indeed active funds are the only funds offering access to micro caps: there is no AIM ETF for example.

Major asset managers such as Baillie Gifford and BlackRock go well beyond traditional investment bank analysis, dedicating increasing resources to funding academic research studying deep market trends. Understanding the evolving economic conditions and technologies that open up new markets helps asset managers identify new themes, and the companies best placed to take advantage of them. They also have increasing access to machine learning tools that help assess market sentiment, cleansing and analysng volumes of data from sources such as analyst reports, annual reports and economic forecasts.

Access to small caps


Well established funds, notably investment trusts, are able to offer investors exposure to broad portfolios of assets that encompass stakes in companies that have not yet come to market. By providing capital to growing businesses which are not yet cash generative and which are not yet – and may never be – interested in a public market listing. Big funds can offer exposure to rapidly growing private companies. They also have scope for the diversification necessary to even out returns, investing across asset classes.

An interesting Investors’ Chronicle survey offers some evidence for the capacity of active managers to identify the less researched companies down the market cap scale that may have been mispriced. The survey found, for example, that as of the end of October 2020, more than 80pc of the active funds in the Japanese Smaller Companies sector came out ahead of the MSCI Japan Small Cap index over one, three and five years. And a similar proportion of funds in the UK Smaller Companies category were ahead of the Numis Smaller Companies ex Investment Trusts index over three and five years. 

But the results were much more mixed for funds trying to pick winners in larger indices. UK and European equity funds only tend to beat the index around half the time over three and five-year periods, not just in developed indices like the FTSE and S&P 500, but also emerging market indices dominated by a cluster of well established companies. Index concentration makes it hard to outperform when a market’s big players have momentum behind them. The S&P 500 or NASDAQ, for example, have powered forward in recent years on account of the momentum of big tech and clean energy stocks like Apple, Alphabet, Facebook, Microsoft, and Tesla. Asian and emerging market indices have been dominated by the likes of Tencent, Alibaba, Samsung, and Taiwan Semiconductor Manufacturing Company. When these powerhouses are performing well active managers can’t do much more than weight their portfolios towards them.

But opportunities do exist for good active managers in markets that are not so dominated. The FTSE All-Share Index, which has performed significantly less well than some of its peers for some years now, offers a good case study.

Over the past 20 years, total returns from the All-Share have been 118pc, equating to a compound average growth rate of just under 4pc. The S&P 500, meanwhile, has powered ahead, up by 245pc over 20 years, or an average annual growth rate of 6.4pc. Quite simply, the biggest US companies are global leaders with much better growth prospects than the FTSE’s main players, a relatively sedate set of banks insurance companies and oil and gas companies.

But the UK, like other developed economies, certainly has its fair share of dynamic medium and smaller-sized companies offering, it would seem, abundant opportunities for good UK fund managers to shine. And yet their performance has been relatively poor.

Closet indexing


Another useful Investors’ Chronicle study looked at a sample of 89 actively managed UK equity funds in the UK All Companies sector and the distribution of their returns up to October 2020. Not surprisingly perhaps it found that none delivered a positive total return against the All-Share Index, which at the time of the article’s publication had fallen by 19.7pc. 

But many funds tracked suspiciously close to the index, evidence of one of the most notorious tendencies of active fund management: the institutional pressure on many managers to stick close to the make-up of the index they are trying to beat. The phenomenon of ‘closet indexing’ refers to the conservative approach of fund managers anxious not to take risks that might make them significantly underperform market benchmarks. The focus is not so much on delivering the highest risk-adjusted returns for their customers as on not losing customers in the first place. By putting together portfolios that aim to slightly outperform the index if things go well, and to slightly underperform if they don’t, managers try to take advantage of the reluctance of many investors to switch funds.

If an active fund doesn’t deviate much from the index it begins to look very expensive indeed. FT commentator John Kay suggests the useful exercise of dividing the quoted management fee by the ‘active share’ the total of deviations from the benchmark index. If the active share is 20pc and the management fee is 0.75pc then investors are effectively paying 3.75 per cent for the manager’s limited stock selection. At that price it needs to be a very, very good selection.

The fund manager’s dilemma can be appreciated. Deviating too far can lose them a lucrative career, many remembering the tech boom of the late 1990s when good contrarian managers who refused to own massively overvalued stocks came under fire – before the market crashed.

Conviction portfolios


But some managers who have managed to escape institutional pressures – often those who have broken away to set up their own funds – have shown that having the courage of their convictions can pay off. The UK’s most successful funds tend to offer concentrated stock portfolios – no more than 40 or so – that take sizeable positions in quality growth companies, and so look markedly different from the All-Share Index. Some of these conviction portfolios have significantly outperformed the market for several years.

This would seem to be active fund management at its best. The customer is paying the manager to undertake quality research to identify quality companies, and to have the confidence to back them. These funds practice all the virtues of successful private investors, picking a concentrated portfolio of good stocks, but with the advantage of the research resources available to a profitable investment house. As Kay puts the argument, ‘asset managers should differentiate themselves, not by spurious promises of risk-adjusted outperformance relative to some broadly based benchmark, but by proclaiming their distinctive philosophy and style’.

Funds and natural selection


It has been suggested that as passive fund market share increases more opportunities for active managers will open. Andrew Lo at MIT proposes a nice analogy with population cycles in biology. If a species becomes abundant, it depletes its food source, and begins to decline. That allows the food source to grow back, allowing species numbers to recover. Lo suggests active managers are like a super-abundant species, hunting in packs for mispricings and eliminating many of them. As their numbers have declined passive funds have had room to grow. But with fewer active managers around, mispricings will again appear, allowing active managers to reappear at the expense of passive managers. A nice theory, a passive advocate might reply: but it only applies if fund managers are good!

Blending active and passive


It’s a complex debate, but it seems that private investors might be well advised to consider a blend of active and ETFs. ETSs might be used as the low cost building blocks for a portfolio, giving low cost, transparent access to efficient markets, and exposure to emerging investment themes. Active funds can be used to access the deeper reaches of the markets, especially small caps, and to take advantage of the conviction strategies of proven fund managers.


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