May 2015 - Active versus passive fund management
Passive funds aim to mirror an index and, in fully replicated form, will hold the exact same amount of each of the constituents which make up that market. Net of fees they will never beat the index, but the outcome will be pretty consistent.
Active fund managers, on the other hand, do their best to build portfolios with the expectation of beating a particular index over the long run, but it cannot be denied that many do so with varying degrees of success.
If few fund managers constantly beat their benchmarks, should we abandon the search for them and choose the passive route instead? The answer, as with any form of passionate debate, is never straightforward.
The are a number of contentious issues. Fees - passives are usually cheaper. However, cheap does not necessarily mean better. Benchmarks - an increasing number of managers eschew them and, before long, there will be nearly as many benchmarks for the passive managers to copy as there are stocks. Many active funds see manager changes, which can impact performance whereas passive funds are managed to a fixed process and not by a manager as such. Passive funds buy expensive stocks and sell them cheaply; as a stock rises in price relative to other stocks its weighting in an index rises, so the passive manager has to buy more. As more money flows into passive portfolios this effect gets magnified. At the other end of the scale stocks that fall in price and become attractive to value managers are sold.
Without an extensive knowledge of the 3,500 onshore funds available to UK investors, it will not be easy to find consistent performance amongst active managers. Many of the serial under performers are the closet benchmark huggers. In the name of controlling risk their portfolios look and behave very much like the index itself; in other words they take very little “active” risk. The index itself has no management fee attached so these funds nearly always underperform as their likelihood of outperforming after fees is very small given the small “bets” that they take.
Other managers may take more active risk, i.e. investing a larger amount in a company they like, or not owning a company at all if they think it is unattractive. They can, however, fall into the many traps the market sets for them. Behavioural biases can prevent managers from running profits and cutting losses, getting into a trend too late or out too early and many other ways of letting their egos get in the way of rational decision making. Passive funds, by definition, don’t suffer from any of these behavioural biases, but by buying high and selling low, their methodology could also be described as counter intuitive.
At FundCalibre our initial screening process, using the proprietary AlphaQuest system, addresses the problem of which of the 3,500 fund managers has a high (better than 60%) probability of generating outperformance. In the long run such managers will comfortably outperform passive strategies - see table below. It is the focus on short-term performance that does much to force the debate, and is addressed in the qualitative stage of our analysis. It is vital to know what the fund manager is setting out to achieve, otherwise our aspirations will not be met. A growth fund investing in tech and start-up businesses will perform very differently from a value-orientated recovery fund. Over the long term the results could be similar, but there will be periods when one is going up in value and the other is going down and vice-versa.
Short-term “underperformance” is something to be expected, as market sentiment moves temporarily against a manager's long-term purview and is not a valid reason to take the passive route. Our interviews with the fund management teams are designed to give us a significant degree of comfort in the investment process that they are following. Do they have a method of adding value and can they demonstrate consistency of approach? Are they aware of the traps to avoid? Do they invest their own money in the fund?
Managers with a good AlphaQuest score and ticks in all the boxes in our qualitative assessment qualify for an “Elite Rating” but we will only award these where we believe the manager has “Elite” status. In other words, the manager shines above his peers. Taking the UK All Companies sector as an example here is a performance table of FundCalibre Elite Rated funds showing 1, 3, 5, and 10-year performance, where available, relative to the index. There are short-term periods of benchmark underperformance, but the long-term record speaks for itself and validates our preference and process for selecting active fund managers.
- Source - FE Analytics 06/05/2015
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Clive Hale, Director – May 2015
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