This week’s Financial Question is about the ‘active v passive’ management debate.
QUESTION: Duncan, intuitively I’ve always believed that ’active fund management’ was the right strategy for my portfolio, but colleagues in the States tell me that the academic research suggests otherwise. What’s your view?
ANSWER: One intuitive, albeit misguided suggestion is that an active manager can alter a portfolio’s makeup to invest in defensive stocks or in cash to protect against, or benefit from, an impending or ongoing bear market, while an index fund manager must adhere to the stated objective of tracking a benchmark’s return regardless of market direction.
With such a statement we presume that the active manager has the power to foretell the future. Not a trait common in most human beings. So it comes as little surprise that when past performance is examined in detail, we find little evidence to support the theoretical benefits of ‘active management’ during periods of market stress—in fact, active managers have consistently failed to deliver superior performance relative to a passive benchmark during such periods. And remember you pay substantially greater fees for the privilege of active management, so it can be worrying, indeed embarrassing to discover that these additional fees only make the task of the active manager more difficult. These are the findings of Vanguard Investment Counselling and Research.
In ‘The Case for Indexing’ (source: Philips and Ambrosio, 2008), Vanguard showed that the U.S. active management universe performed inconsistently during and immediately following U.S. bear markets. Using average excess returns, Vanguard was able to show that in 3 of 6 bear markets since 1970, active managers failed to outperform the U.S. stock market. In addition, research found inconsistent performance immediately following the bear markets. If we surmise that the primary difficulty facing active managers is that in relatively efficient markets, it is difficult to consistently and correctly time market moves and to consistently identify winning investments across market cycles. It can be shown, in keeping with the concept of the zero-sum game, the combination of cost, security selection, and market timing proves an almost insurmountable hurdle to overcome in any market environment.
During periods of market stress, it is common to hear that active managers can help investors by selecting securities or by maintaining a significant cash position. However, evidence does not support this. It can be shown that actively managed funds, on average, tend to underperform a broad market benchmark. In addition, it can be demonstrated that past success does not ensure future success. There would appear to be little consistency with respect to outperformance. Sadly, for the active investment management industry, it can be shown that despite some evidence of outperformance during bear markets, bull markets brought significant challenges for active funds.
Overall, this analysis concludes that while there will always be a group of funds that outperform in every market cycle, consistently selecting those winning funds in advance is difficult at best. When accounting for the difficulties in identifying bear and bull markets, security selection, and the difficulty in overcoming higher costs over the long term, it should be concluded that an indexed investor is not at a disadvantage when investing in bear or bull markets. Furthermore the significant reduction in management fees associated with passively managed funds should result in consistent outperformance of active fund managers. Institutional investors have known these facts for decades. This is where the smart money goes, in good times and bad.