Passive vs Active
What is the difference? An actively managed mutual fund will try to pick the best 100-200 stocks listed in an Index. A passive fund, or index fund, would just own all 500 stocks that are listed in the Index.
Each and every year, academic studies are done comparing the returns of actively managed funds to the returns of passive funds. Each year, studies show that actively managed funds rarely have returns higher than their passive counterparts.
As a matter of fact, when you look at large cap funds, 70-80% of the time, you will have a higher return by owning an index fund than by trying to find an actively managed fund that can beat the index.
Summary of the Evidence
Between 1998 and 2008, only 23% of UK fund managers beat the market. (Morningstar). There is also a study by Barksdale & Green that shows that of the funds that have been in the top 20% of funds over a five year period, there is only a 44% chance they will be in the top 50% of funds for the next five years. Additionally, those funds that are in the bottom 20% of funds in the first 5 years, have a much greater chance of remaining in the bottom 50% of funds over the next 5 years.
Those that do beat the market, do so by random and they will not do this consistently.
In the first major study of Fixed Interest/Government Gilt funds performance, Blake, Elton and Gruber in 1993 examined 361 bond funds for the period starting in 1977. They compare the various active funds to simple index strategy alternatives. They found that the active funds, on average, underperform the index strategies by 0.85% a year. Depending on the benchmark, between 65% and 80% of the active funds have inferior returns.
In a study of equity mutual funds, Elton, Gruber, Hlavka and Das examine all funds that existed for the period of 1965-1984, 143 funds in all. These funds are compared to the set of index funds - big stocks, small stocks and fixed income - that most closely correspond to the actual investment choices made by the mutual funds. The result was that on average these funds underperform the index funds by a massive 1.59% per annum. Not one fund generated positive performance that was statistically significant. In the most recent and comprehensive study done to date, a dissertation at the University of Chicago, Mark Carhart studies a total of 1,892 funds that existed any time between 1961 and 1993. After adjusting for the common factors in returns, an equal-weighted portfolio of the funds underperformed by 1.8% per year.
These studies, along with earlier studies, provide a fifty-year history of professional investment management. The message is clear: the beat-the-market efforts of professionals are impressively and overwhelmingly negative. In any asset class, the only consistently superior performer is the market itself (a passive strategy).
Of those managers who do manage to beat the market over a period of time, only 10% will beat the market by skill, rather than luck (Kowolski et al 2001). The problem investors have is that you can’t select the excellent managers (i.e. Anthony Bolton) in advance. Non-one knew in 1979 that he would become one of the best fund managers ever. In 1989, after beating the market by 8% p.a. for 10 years, you might like to invest, but if you had, and then looked at your fund 3 years later he was 45% down on the market. What do you do? Sell, hold?
In a 19 year period up to 2002, the US market beat the average active fund by 3% per annum.
If we look at this in a mathematical sense, the market will always beat the average investor. This is a fact, not a theory. This is because the market is made up of all investors and as such, the market return is the return of the market before costs. (Professional managers, IFAs, buying & selling costs, administration costs).
If you take the fact that the average all in cost of a UK equity fund exceeds 3% p.a., and that the long term return of equities (over and above inflation) over the last 100 years is about 5% p.a., this means the industry is potentially taking 60% of your returns.
Another key reason why active funds tend not to beat the market is explained by the Portfolio Turnover Rate – some of this is accounted for in the Annual Management Charge levied on a fund. But the Financial Services Authority has proven that by trading the value of the fund in 1 year, the additional cost added on is 1.8%. Given that this is much higher than the AMC anyway, and that the average Portfolio Turnover Rate for a UK fund is 90%, this adds on average another 1.6% to the annual running costs of the average active fund. Indeed, many funds have more than 200% annual turnover rate.
A UK study W M Company also in 2001, compared actively managed unit trusts in the UK All-Companies sector against the FTSE All-share index, for the 20 year period to the end of 2000. The main finding was that the market return was in the top quarter of returns. 44 out of the 55 unit trusts with a 20 year record failed to beat the market over this period.
When index funds were introduced to the UK in 1989, over the subsequent 12 years, 80 out of 115 active funds failed to beat the market.
Asset Allocation
The debate regarding Active versus Passive management of investments, shows how passive funds almost always perform better than active funds, but how do you construct a meaningful portfolio of these passive funds?
The next step in trying to put together a sound investment portfolio is explained by many academics both in the past and in the present, as being key to the investment process.
Back in 1952, the soon to become Nobel Prize winning Economist, Harry Markowitz presented his findings on ‘Modern Portfolio Theory’, a theory that was about to change the way the world would look at investment.
Prior to his work, people went about constructing portfolios focusing on the risk and potential return of individual securities, for example working out if the risk of investing in Marks and Spencer shares was worth the potential return. His work proved however that people should actually be making their investment decisions based on spreading the investments across different sectors, so that if you were investing in another share, this should be something unrelated to the price movements in Marks & Spencer shares, maybe a computing firm. The evidence states that by diversifying the risk of the portfolio, you could not only reduce your risk, but maximise your return.
Stockbrokers and discretionary investment managers still operate on this basis, and although some of them are immensely intelligent people, there is no evidence to suggest that they are able to make correct decisions on a regular basis to beat the market average.
Markowitz also took this one step further: that for every specific level of investment risk, there is an optimal combination of asset types that will maximise the expected return. i.e. there is a way of increasing the expected return, without adding more risk. By this he means that over time, by combining the main asset classes (Cash, Property, Fixed Interest and Equities), into a portfolio via a process known as 'Mean Variance Optimisation’ you can achieve a scenario for each investment that will provide your investments with the highest expected return for any given risk level.
I have used this process in conjunction with Ibbotson Associates, the leaders in this area, and have developed portfolios that have the ideal selection of assets for each risk level. They have been compiled using detailed data on historical returns, the volatility of returns in relation to the other types of assets, and their correlation of returns (i.e. if the UK equity goes up by 3%, what happens to the index linked gilts).
As I have already mentioned, there is evidence that confirms only 23% of UK investment managers beat the market over 1998 to 2008, and that trying to select those who will do it in the future is an impossible task, completely random by its nature. Therefore, by constructing a diversified portfolio based on scientifically tested data, this provides you with the crucial ability to build the portfolio that matches your risk, and allows you to stack the probabilities of success in your favour therefore minimising the risk of your investments performing poorly.
Our strategy involves keeping the costs low, and leaving as little to random chance as possible. University professors and various industry leaders have produced studies that are independent of the marketing and spin of the investment companies, and based on fact.
The most notable study in this field was completed by Brinson, Hood and Beebower in their 1995 paper published in the Financial Analysts Journal. They prove that Asset Allocation is the most important determinant of investment performance, not the active management activity of market timing, nor stock selection.
In 2000, Ibbotson and Kaplan used 5 asset classes in their study "Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?" Ibbotson concluded 1) that asset allocation explained 40% of the variation of returns across funds, and 2) that it explained virtually 100% of the level of fund returns. Brinson has expressed his agreement with the Ibbotson-Kaplan conclusions.
This paper is still widely accepted as being the most accurate piece of research on this subject.
Market Timing
This is proven to be almost impossible to do correctly over a period of time. A study by the Nobel Prize winning William Sharpe in 1975 shows that in order to make just the same return as the market (i.e buying and holding), using data from 1929 to 1972, you would need to make the decision to switch between Equities and Gilts correctly 70% of the time.
This is an extremely high hurdle, and also this takes no account of transaction costs, nor the taxes that may be incurred by buying and selling regularly.
A key study of American investors by Dalbar in 2002 showed the average investor turned $100 to $90 in the 19 years from 1984 to 2002. This was the period of one of the longest rising stockmarkets in history. This occurred by investors chasing returns, moving from one fund to another, just because certain funds or asset classes where deemed best at any one time. This is a buy high, sell low strategy, and is likely to fail. During the study period, a simple buy and hold approach turned $100 to $500.
The moral of the story is to stay invested and whilst you will have to take the rough with the smooth, history tells us that trying to switch out of assets and beat the market does not work consistently, and that whilst you may get this right some of the time, no one can do this well over time and this actually it can cause more harm than good, trying to seek positive returns in all markets.
One such study by Fidelity illustrates just how difficult it is to actively manage money, and if you get the timing slightly wrong, the consequences can be enormously damaging. This data shows the average annualised return over the 15 years to 30.04.2009.
Martket : FTSE All Share
Full Invested : 5.6%
Best 10 days missed : 1.4%
Best 40 days missed : -5.5%
(Source: Datastream as at 30.05.09 / Fidelity study)
Hugo Balfour-Melville 2009