To be active or to be passive? That is the question

Coke or Pepsi? Elvis when he was thin or Elvis when he was fat? Active versus passive? There are just some ongoing feuds that show no signs of ever having a winner declared.

Sometimes trying to resolve the argument almost seems an exercise as fraught with futility as asking whether Mr Wile E. Coyote will ever catch his land-bound avian nemesis, Geococcyx californianus.

But more on that later.

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At any rate, there are plenty of reasons why the active versus passive debate shows no signs of easing.

Nikko Asset Management senior portfolio manager, Darren Langer, believes that while the two terms can mean different things depending on what kind of investor you ask, a lot of issues simply come down to cost.

“Everyone wants something for nothing,” Langer says.

“It’s hard to say from a manager’s point of view what’s right and what’s wrong because I think everybody’s circumstances are different.

“The things that matter from an investment management point of view is that what you’re ultimately trying to achieve matters more than the style, and things like that. And in some instances, active managers provide something that you can’t get from a passive market investment.

“So, it ultimately depends on what your investment objectives are – that’s probably the first thing you need to define before you make a decision about active or passive.”

But personal circumstances and investment objectives aside, price will always be a factor in investors’ decision-making processes.

“Obviously we’re in an increasingly volatile investment environment now, and I guess as a result of that, investors are probably more focused than ever before on what’s known as value for money,” says Ilan Israelstam, BetaShares head of strategy and marketing.

“And as a result, they’re increasingly scrutinising the performance of active managers versus the fees they’re actually charging them - and the truth is that for the bulk of active managers, the numbers aren’t good.”

Israelstam points to a recent SPIVA report, which is a “report card” provided by S&P that compares the performance of active managers and their benchmarks, which showed that for a 10-year period to the end of 2017 only 25 per cent of Australian active equity managers outperformed their benchmark.

The story was worse for international equity managers, with only 10 per cent outperforming, Israelstam points out.

“So, I suppose with those kinds of numbers … investors and their advisers are realising that one of the few things they can control here is fees and given the poor results we’re seeing from active managers, there’s no doubt that this debate shows no signs of easing.”

However, Israelstam is quick to point out that it still makes sense for investors to have a mixture of both active and passive exposure in their portfolios.

“I think it does make sense to have a mixture - I’ll unapologetically say that I think that passive can easily make up a very significant core of your portfolio … but there are certain asset classes, there are certain managers that do add value … or sometimes there’s a particular information edge or something else that they have which would not be possible in a passive environment,” he says.

“So, we often look at things like emerging markets and small caps as examples of those.”

One interesting data point that Israelstam raises involved looking at all active and passive flows in the US market for the first four months of 2018.

He notes that net inflows into active strategies were essentially flat at $1.2 billion - while passive net inflows stood at a whopping US$160 billion.

But all asset classes are different, right?

According to Dr Jamil Baz, co-head of client solutions and analytics at PIMCO, investors need to remain aware that “bonds are different” when it comes to the active versus passive debate.

“Ask an investor if most active bond funds outperform their passive counterparts and the response is likely to be ‘no,’” Baz says.

“After all, if one investor beats the market, another must lag it. Active strategies incur higher fees, so the majority should underperform their lower-fee passive counterparts. Recent media coverage on the rotation from active to passive funds – although focused chiefly on the equity market – may only reinforce this perception.

“Our research suggests otherwise – at least for bonds, if not for stocks.”

Baz believes the reason why active bond strategies have been more successful than active equity approaches over the past five years lies in the bond market’s unique structure.

“Noneconomic investors make up roughly 47 per cent of the $102 trillion global bond market. Central banks, insurance companies and other noneconomic investors typically have objectives other than generating alpha,” he explains.

“Central banks, for instance, may buy bonds to weaken their currency or boost inflation and asset prices. Commercial banks and insurance companies may care more about book yield or credit ratings than total return. The result: noneconomic investors leave alpha potential on the table for active bond managers.”

Also, Baz points out that the composition of bond indexes changes frequently.

“When fixed-income securities join or leave an index, their prices tend to rise or fall as passive investors rush to buy or sell. Active investors seek to anticipate and profit from these changes.”

Baz also notes that bonds, unlike stocks, mature after a number of years, leading to more turnover in the bond market.

“New securities make up about 20 per cent of bond market capitalisation annually, compared with about 1 per cent in equity markets. Importantly, they typically are offered at concessional pricing to drive demand,” he says.

“Yet these discounts are generally not available to passive managers, who tend to buy new securities when they join an index, often a couple of weeks after they’ve been issued.”

Lastly, Baz says that structural tilts can be an important source of durable added value.

“Active managers, for instance, can target factors such as duration and exposures to high-yield credit, mortgages, high-yielding currencies and other sources of potential alpha,” he says.

In short, Baz says that informational efficiencies make beating equity markets difficult.

“But we believe that’s not the case with fixed income, where non-economic and passive investors pursue agendas that are not exclusively about total return,” he says.

“Put simply, bonds are different.”

ACME rockets not always reliable

But if there’s one caveat that every investor has heard repeatedly when it comes to discussion surrounding any asset class you care to name, it’s that past performance is never a guarantee of future return.

In other words, a certain strategy or product that worked yesterday may not work tomorrow – just ask any cartoon coyote.

Warryn Robertson, a portfolio manager/analyst with Lazard Asset Management, says if an investor simply went back to the Global Financial Crisis and just simply put money in the market, they would have done “pretty well”.

However, that is no longer necessarily going to be the case, Robertson says - and continuing to believe that just buying the market and expecting the beta to save you is possibly “the worst decision that an investor could make right now”.

“We would contest that today, across the range of strategies that I look at but particularly global equities, if you buy an index or a passive exchange-traded fund (ETF), with a broad range, diversified portfolio across 100 plus names, you’re guaranteed to lose money,” he says.

Robertson says that, at present, markets are generally expensive. If investors look at traditional measures of long-term value such as the CAPE ratio – a valuation measure that uses real earnings per share over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle – he says markets have only looked more expensive on two previous occasions.

And these were March 2000, the culmination of the tech boom that preceded the subsequent “tech wreck,” and then in the events of October 1929, just prior to the onset of the Great Depression.

“So, just on pure measures of long-term value, markets look expensive,” he says.

So, what Robertson and his team are doing is concentrating portfolios in a select few companies that they think can still achieve their long-run objective of an absolute return over five years of about 10 per cent per annum.

“And if you want to achieve that today, you’ve got to be really selective about the investments that you make because there are very few companies that we think, using conservative assumptions, will achieve those sorts of outcomes,” he says.

In a somewhat perverse situation, Robertson says while people may often think they need to diversify in an effort to reduce risk, he says this is the “absolute wrong thing to do today”.

Rather, predictability of earnings is the key criteria that Robertson looks for.

“If I can make my life easy by selecting companies that are more predictable, I’ve made my investment problem – that’s the job of every investor, it’s to solve an investment problem – I think I’m making that job easier,” he says.

And while an investment universe of, say, 250 stocks, may encapsulate a number of great companies with “lovely” characteristics and competitive advantages, if you were to go buy all 250 stocks in an effort to diversify a portfolio, Robertson says an investor would likely stand to lose between 10 and 15 per cent per annum.

And, on the way Lazard values stocks, two thirds of the manager’s investable universe would give investors a negative return.

“The key today, we think, if you want to manage money for the medium term, is to buy the right business, but more importantly, to pay the right price,” he says.

Wile E. Coyote has gone off the cliff …

And with markets ebbing and flowing alongside short-term issues such as the political situation in Italy and Trump’s ongoing games with Kim Jong-un, Robertson says investors have acknowledged that we’re currently in difficult territory.

Echoing a recent analogy from former Fed chair Ben Bernanke, Robertson says: “I like to categorise things with pictures, so I think about the Road Runner and the Coyote. We’ve run off the edge of the cliff and the Coyote’s standing there and he’s looking back but he hasn’t looked down – it’s when he looks down that everyone is going to start to worry.”

Robertson believes the moment when the Coyote looks down will be after Trump has reached the end of a path of fiscal instability and ill-discipline, after having let a US$1 trillion a year government deficit to grow too far.

“It’s a difficult market to invest in with a lot of confidence … as always we think the way to best way to navigate investments throughout most markets and most periods of time is to really be careful about the companies you want to own, but then most importantly, and particularly now, you’ve got to pay the right price for them,” he says.

“Over the years I’ve heard too many consultants and analysts say, ‘As long as you buy the right company, in the long run it’ll be okay.’ If you buy a business that is priced at twice what it’s worth, the long run won’t save you.

“You can do as much portfolio analytics as you like … the way I can manage for risk is to make sure I don’t overpay. And the best way to do that … if I can define my universe of opportunities as predictable businesses then the investment problem is much easier for me to solve because I have half of the equation as an easier problem.”

Robertson says a lot of ill-discipline has recently crept into a lot of managers’ market valuations, with some investors not changing their earnings growth assumptions, but instead lifting their discount rate, which is generally negative for valuations.

“That’s why we’re negative on markets generally and telling our clients: ‘You must be concentrated.’”

Robertson believes the active versus passive debate will continue to be ongoing as long as markets remain favourable to simply “being in the market”.

“Passive is clearly cheaper but it’s all about the risk-adjusted return. And when the beta is doing well for you then passive has it’s time in the sun – it’s when markets go negative and you actually need someone who can sit over the top and can make valuation calls around, ‘I don’t want to own that stock because it’s expensive,’ or as I said, ‘Two thirds of the companies that are wonderful that I look at are going to lose you money – I need to concentrate on the select ones,’” he says.

“That’s why … today is not the place to go passive. Longer term, why would you do that? The balance between what you pay as for and what you get is always the investment problem I try and solve and it’s the asset allocator’s issue as well.

“So, if they’re not getting a risk-adjusted return that’s above the index, well then clearly you would always go passive. But you’ve got to look at that equation when you’ve had both negative and strong positive markets, and we’ve had that over the last couple of years.

“So, that’s why I think the passive debate gets a really good run. It has just been an extraordinary time to be in the market. That has really been part of the push to go to passive.”

Also, Robertson says, Australia has seen a recent obsession with fees, which he describes as a dangerous path to go down in many respects: “If you’re just going to buy the index … I think you’re guaranteed to lose somewhere between 10 and 15 per cent per annum over the next three years.”

“It’s not the time.”

But why not have both?

Timing may therefore be one of the key factors in declaring an eventual winner in the eternal struggle between active and passive proponents.

But before that happens, Andy Sowerby, Legg Mason’s head of Australia, suggests that investors may simply need to rethink the parameters of the debate itself.

“Whilst this debate does seem to rage on we continue to think this is the wrong conversation,” he says. “For us, active and passive strategies are ideal partners, complementing each other in order to enable investors to build better long-term investment solutions.”

For Sowerby, it “absolutely” makes sense for investors to have a mixture of both passive and active strategies within their portfolios.

“Passive can help control costs and give market returns. Active can help enhance returns and deliver more stable outcomes for investors,” he says. 

“Why would you restrict yourself to one or the other? I think both have a value proposition, both have strengths and weaknesses, and ideally you would want to use the full toolkit in constructing a solution for a client.”

Also, Sowerby believes active strategies and ETFs can have their place within both the core and satellite portions of investors’ portfolios.

“I mean, clearly there has been much written about market-cap passive strategies providing cheaper beta exposure … but adding well-constructed active strategies - both in the core and in the satellite - can help enhance returns and reduce the volatility of returns over time.”

Therefore, as Sowerby is keen to point out, perhaps the whole discussion should not be thought of in terms of “either/or,” but in terms of “and”.  

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