Is passive investing a better investment strategy than active asset management? Or, as seems intuitive, should active management provide higher net returns? Intuition is nice. But what does empirical evidence tell us in the passive versus active management debate?
“Does active asset management outperform a passive strategy?”
Some empirical studies have found that active management can produce “alpha”. That is, the managers have been able to outperform their benchmark indices in net investment returns.
“So why the debate about passive management?”
Unfortunately, there are many other studies that have found that active management does not consistently outperform over time.
If you search the internet, you will find research that suggests one or the other is preferable.
“Forget the studies. Can you show me some actual performance data?”
So, let us review some empirical data of our own. If we look at recent Morningstar data on actively managed funds in the US, some interesting inferences may be drawn.
It is indeed, very difficult, for active managers to consistently outperform their benchmarks over longer time periods.
There are a few areas where active management may be preferable. But, in general, it is hard.
In future episodes, we will discuss why achieving active manager “alpha” is not easy. And possible areas where active management may be useful.
Should you hire an investment professional to help manage your wealth? What types of investment professionals are out there? What advantages and disadvantages may exist for investors in paying for an investment professional’s services?
“What are the common types of investment professionals?”
The three professionals that individual investors usually encounter are asset managers, research analysts, and investment advisors.
Asset managers make the investment decisions. Whether that be in an investment fund or a discretionary portfolio. As an investor, you decide on the manager and then let them make all the portfolio decisions. Your only input is to invest or divest in the portfolio itself.
Research analysts review investments and recommend them for inclusion (or exclusion) in a portfolio. You may see them in fund rating services, such as Morningstar. In Yahoo Finance and other investment news aggregators. Provided by your investment broker as potential investments. You may even subscribe to analysts for proprietary information and recommendations.
Investment advisors tend to the be the actual professionals you will deal with on a regular basis. That may be a commission salesperson or bank employee. Where you receive “free” advice. It may be an advisor who charges an annual percent fee based on assets. Or, it could be a fee-only advisor. Who charges hourly or flat fees based on the services rendered.
“What are the potential advantages in working with a professional?”
There are a few typically cited.
One, a professional should have strong technical expertise. Much more than most individual investors.
Two, depending on the professional, he/she may have many years of investing experience.
Three, the professionals will have access to better analytical tools and data.
Four, it is their job. If you are a doctor, engineer, teacher, etc., you work a full day in your field. Hard to compete with a professional who is analyzing investments and strategies full-time. While you are devoting an hour or two an evening.
So, many potential advantages in working with an investment professional.
“What about potential disadvantages?”
Yes, a few of those as well.
One, as in any profession, some are better and some are worse. You need to do proper due diligence on to find a competent professional.
Two, professionals may not cover niche or neglected markets. If the professional you rely on is an expert in US large-cap equities, will they have any skills in the Western Canadian junior mining sector? Swiss small-cap domestic markets? High yield bonds? An amateur investor with expertise in niche markets may do a better job than a generalist professional.
Three, investment professionals are not free. Usually, not even inexpensive. Even that “free” advice from a fund salesperson or bank employee has fees embedded in the annual product costs. Are you getting value from the asset manager, research analyst, or investment advisor?
Four, tied in with point three, is there added value for the cost? If the asset manager charges you 1.0% per year, does he/she generate at least 1.1%? That is the key issue with investment professionals. Does active asset management provide excess returns over the cost paid by investors?
This latter issue is the age old, “Active versus Passive Management” debate. Not surprisingly, that will be the next issue we delve into.
An introduction to the age-old “Passive versus Active Asset Management” debate. What is passive investing? What is active investment management? How do they differ? What are the keys to success when implementing a passive or active investing strategy?
“What is passive investing? What are the keys to success in passive management?”
Passive investors do not attempt to “beat the benchmark”. They simply invest in the entire market.
That may be a broad market, such as the S&P 500. It may be an asset subclass. Australian mining companies. High-Yield corporate bonds. Regardless of the chosen benchmark index, passive investors just invest in the market.
Passive investors do not actively trade. They invest in the market and try to match the benchmark return as closely as is possible. Passive investors also work to minimize their investment costs.
Identify the asset class and subclass to invest in. Match the market return. Minimize investment costs.
“What is active investing? What are the keys to success?”
Pretty much the exact opposite.
Active asset managers believe they can outperform their benchmarks. That they can achieve “alpha”.
As with passive investing, the benchmark can relate to broad or narrow asset classes and subclasses.
There may, or may not be, extensive trading. Active refers more to the ability to trade and select specific investments. Not the requirement for constant buying and selling of assets.
Cost consciousness is probably nice. But active managers are primarily concerned with outperformance of their portfolio’s net returns. If it costs 2.5% per annum to actively manage an investment fund, the only issue is if the managers can generate 2.51% in excess performance.
Within the designated benchmark index, identify the “best” investments. Invest, then adjust over time as market conditions shift and/or “better” investments come along. As long as the active manager can generate “alpha”, costs are not a major concern.
Find the “best” investments. Outperform the market return. Costs, meh.
“Why the “debate”?”
On the surface, it seems obvious that active asset management should easily outperform a passive approach.
For example, perhaps my benchmark is the S&P 500. This consists of (approximately) 500 US large cap equities.
As a passive investor, I simply buy all 500 companies in their index allocation. Usually via an index mutual, or exchange traded, fund.
As an active investor, I use my professional skills and experience to analyze all 500 companies. I discard the worst 200. Ignore, or underweight, the middle tier stocks. And load up on the 25-100 companies that I consider to be superior investments. As conditions change, so too does my portfolio.
The passive investor is saddled with all 500 companies. The good and the bad. The active manager only invests in the “best” stocks.
So why is there any debate?
A professional investor who can pick and choose will outperform a passive investor all the time.
What are mutual fund “shenanigans”? Factors that can distort your ability to properly review and assess a mutual fund’s investment performance. Including: intentional or accidental actions by fund managers; survivorship or creation bias; portfolio style drift; window dressing.
“How can the fund managers affect my ability to assess fund performance?”
In a few ways. Some may be intentional by fund management. Or simply accidental.
If you are analyzing results from the last 5 or 10 years, who generated those returns? Current management? Or was the current team only brought on in the last 3 years? That can be bad if a superior group of asset managers left. But it may be good if a new unit was hired to replace underperformers. In either instance, difficult to attribute longer term performance to a team that did not create the results.
Perhaps the 5 to 10 year performance was all during one type of market. A bull market, where everyone does well. How will the management team perform in volatile conditions or a bear market? Usually useful to assess how managers perform in different market conditions.
Maybe the fund’s managers are “index huggers”. Where the portfolio holdings highly reflect the underlying benchmark index. Yet, as an investor, you pay a management fee for active management. In a relatively small equity market, such as Canada, many large mutual funds may become index huggers by default. Not the manager’s fault. More a reflection of having very limited investment options for very large assets under management. But why pay for that management if you are not getting it?
“What is survivorship bias? How can it impact my performance analysis?”
Underperforming mutual funds may close down. A few reasons why this might occur. The main one being that if you have 10 investment options and one is consistently in the bottom 10%, would you invest in it? If you already owned the fund and saw that it was in the bottom 10% over time, would you stick with it?
The answer to both is (hopefully) no. The fund will not attract new investment capital. Assets already in the fund will diminish as investors sell and move their proceeds elsewhere. With less assets, fund expenses are spread over fewer investors, resulting in higher management expense ratios. Which further dissuades new investors from coming in. At some point, the fund is no longer feasible and is shut.
The problem is that once a fund is closed, it may no longer be included in peer performance calculations. That distorts average returns for the investment category. As well as fund ranking within that category.
There are 10 funds in a category. Your fund is ranked fifth, right in the middle. Not great, but perhaps tolerable. Suddenly, the three lowest ranked funds close. Your fund now sits in the bottom third. Same fund. Same absolute performance. Yet it goes from right in the middle of the pack to nearer the bottom.
To a lesser extent, similar issues may arise with creation bias.
“What is style drift? How can it create fund shenanigans?”
Mutual funds are usually aggregated by investment category and/or style. US small-cap equities. Canadian investment grade corporate bonds. Australian mining sector.
Within a specific style, there tends to be an equal risk-return profile and similar investment universe. Asset managers operate under a somewhat level playing field when choosing portfolio holdings.
Style drift occurs when an asset manager deviates from the stated style. Perhaps taking on added risk, hoping to earn higher returns. The wider the drift, the less comparable performance is between funds in the same category.
A problem for investors in assessing and in the risk they may unknowingly have in their own portfolios.
“What is window dressing all about? Sounds like the store front in my local mall.”
Window dressing is pretty much that. Just before a reporting deadline, fund managers try to make their portfolios more attractive. In the hope that an investor “walking” by, might stop, be impressed, and come in for a purchase.
Window dressing may hide bad investment decisions. Yes, the performance is reflected in the annual results. But when a potential investor reviews year end portfolio holdings, he/she sees Apple, Amazon, Tesla. Not Blockbuster, Kodak, or Enron. That may influence their view of the manager’s skill.
Window dressing can also hide index hugging and style drift.
A fair bit of information covered. However, if you intend to review mutual fund performance, it is useful to understand how the results may be distorted. Always be on guard for potential “shenanigans”.
How to properly assess a mutual fund’s performance? First, compare investment returns on an absolute basis. Then, on a relative basis versus historic results, risk-adjusted returns, fund peers, and customized index benchmarks.
Yes, investment returns should also be compared against benchmarks. By comparing actual results against different variables, it helps ensure that you cover all angles in your analysis.
You can compare actual return versus the fund’s historic results. Are there trends or changes from past performance? What has led to any variances? New fund management? Good (or bad) investment strategies or tactics? Fund costs?
You can analyze fund results on a risk-adjusted basis. Comparing against zero, real, and risk-free rates of return. Or factoring in risk-adjusted return ratios, such as Sharpe, Sortino, and Treynor ratios.
You can assess the fund versus its peers. How does the fund ranks in its investment category (e.g., Canadian bonds, US small-cap, consumer discretionary equities)?
Finally, benchmarks can be created to assess performance. With over 3 million indices available, investors can easily develop bespoke benchmarks to assess investment funds and portfolios.
As you can see, there are many ways to assess a mutual fund’s investment results. On its own, as well as against relevant benchmarks. For additional information on this topic, please refer to “Mutual Funds: Performance” and “Mutual Funds: Performance is Relative”.