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How active funds can hit back

by Matthew Smith | 01 Mar 2017

Is it possible that the reputation of active funds management has reached its nadir?

It certainly feels that way – a confluence of research findings and critical diatribes levelled at active funds managers in recent months has left the industry dizzily wondering how to fight back against the all-pervasive index fund narrative.

Index operator S&P’s latest “scorecard” (which incidentally refers to itself as the de facto scorekeeper of the ongoing active-versus-passive debate) frames local active funds managers’ struggles to keep up with the benchmark

In the northern hemisphere, a study by financial watchdog, the European Securities and Markets Authority (ESMA), resulted in a report warning investors of so-called “closet index huggers” collecting active management fees

ESMA’s report didn’t “name and shame” the closet indexers, but a subsequent study published last month by consumer advocacy group, Better Finance, did, singling out investment firms including the likes of Henderson, Fidelity, JP Morgan and Schroders.

The latest and possibly most authoritative snipe at active funds came from none other than the Oracle of Omaha himself, Warren Buffet, in his yearly address to Berkshire Hathaway shareholders in the last week where he derided active funds for wasting investor capital.

Vested interest

Of course, Buffet has an interest in spending time on the topic; he competes with active funds managers for investor capital. He also identifies Jack Bogle, the founder of mainstream index investing and retired CEO of The Vanguard Group, not just as his personal hero but as a hero to all investors.   

The active versus passive debate is hardly new (what debate is?!), but there’s a fever pitch feeling about it at the moment, possibly because the markets – both locally but more pronounced in the United States – are reaching historic highs, hyped up on loose monetary policy, the remnants of quantitative easing and, more recently, the promise of Trump-style company tax cuts and fiscal stimulus.

There is an argument to be made that the active-versus-passive argument should be less of a discussion about which approach is better, and more of an appreciation that each works in certain market environments, a point made recently by Rupal Bhansali, chief investment officer of New York-based Ariel Investments.

Cyclical not secular

“Outperformance of each approach is cyclical, not secular… studies have shown dramatic reversals occur when the active style suffers bottom decile performance versus passive for several years, and vice versa,” Bhansali says, during a small briefing in Sydney within the last week.

InFinance has entertained the risks of passive’s growing share of the share market in recent months along similar lines to Bhansali.

But for now the momentum – both literally and figuratively it seems – is in the hands of index funds, which are seriously challenging the business models of active funds managers by offering the same and in many cases better returns for a fraction of the cost.

What’s largely missing from the media’s version of the active/passive debate, however, is recognition of where the passive cyclical lifespan ends, and what strategy might be well placed to pick up where the last nine or so years ultimately leave equity investors off.

A good place to start is discussion of active share measurements and tracking error of funds, topics raised in this recent article aimed at retail investors by Macquarie’s Owner’s Advisory. 

US investment consulting firm, Cambridge Associates, outlines the academic approach to the active-versus-passive debate well here.

Pick a winner

Performance of an active manager can also be heavily dictated based on size; how long the fund has been around; and whether the principals actually invest their own money – factors raised in this recent InFinance article.

Standardised ranking of funds management firms has its flaws, a point that Jonathan Berk, a prominent professor of finance at Stanford University’s Graduate School of Business, highlights here

Also worth noting is that comparisons between performance of funds relative to the ASX index and the S&P in the United States are not entirely relevant – investment professionals will highlight that it’s harder to outperform in the US market than down under because the S&P500 is more picked over by investment firms and analysts.

Indeed, investors who are well informed are likely to be happy to pay for active management, instead of opting for a cheap composite of the index ordered by nothing other than market capitalisation.

It’s really up to the funds managers themselves to better articulate what they want investors to pay up for.  

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