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.
A goal of passive investing is to match the market return as closely as possible.
However, it is not a given that a passively structured investment will match its own market. In fact, there may be material variations between different investments and the benchmark index performance.
Index funds (both mutual and exchange traded) are typical passive investments. Here is why they do not normally exactly match their benchmark returns.
Operating Costs
Index funds incur operating costs that are not present in the benchmark index.
While there may be little to no management fees charged, there will still be expenses for: commissions on buying and selling securities; accounting for fund assets; shareholder communications; regulatory filings; staff salaries; etc.
These costs cannot be avoided. Any fund that you invest in will be at an immediate disadvantage in trying to match the market return.
The more efficient the fund, the lower the relative costs. As well, there is often economies of scale for larger funds. Operating costs cannot be avoided entirely. But be sure to compare funds before investing. There will be differences.
Transaction Timing
Even if we could avoid all fund costs, it still may still be difficult to exactly match the benchmark index performance.
Securities need to be bought and sold on the open market to properly track an index.
For example, per a June 19, 2018 S&P Dow Jones Indices news release, “Walgreens Boots Alliance Inc. (NASD:WBA) will replace General Electric Co. (NYSE:GE) in the Dow Jones Industrial Average (DJIA) effective prior to the open of trading on Tuesday, June 26.”
If you are an index fund that mirrors the Dow 30, you may need to sell your holdings of General Electric and replace them with Walgreens. There is no guarantee that the price you receive for General Electric, or pay for Walgreens, will be the same as calculated by the benchmark as at the close of business on June 25. This likely will create a variance in fund performance versus the benchmark.
Compounding this problem is that there are many funds that track this index.
The more funds that reflect a specific index means more competition for shares of securities added to an index and more sellers of securities that have been removed from an index. If there is suddenly either increased supply or demand, it can cause significant price fluctuations.
When a fund can invest and divest securities may have an impact on its performance versus the benchmark. Think of the price impact on General Electric as all the tracker funds holding this stock sell their shares. And what will be the short-term price impact on Walgreens as these same funds buy all available shares of this stock?
Obviously, the smaller and/or less liquid an index, the greater the fluctuations likely between purchase and sale prices on equities entering or leaving the index.
Fund Construction
Variances between performance in the benchmark and index funds may relate to how the fund is structured.
Not all index funds are created equally.
Index funds may be created using full, partial, or synthetic replication.
Full Replication
Full replication involves holding every security in the index in its appropriate weighting.
With complete replication, an index fund’s gross returns should be close to to the index itself.
As the relative weightings of securities can fluctuate based on security price and capitalization, to stay fully replicated may require frequent trading. How quickly the fund can adjust its portfolio will impact matching gross index returns.
Also, increased trading will increase fund operating costs. This reduces fund performance versus the actual index which does not incur any expenses. The increased fund turnover can also create taxable capital gains for investors, once again impairing net returns.
Partial Replication
Partial replication does not hold all an index’s securities. Instead, it only maintains a representative sample of the securities within the index.
The better the sampling techniques, the closer the gross returns should be to the index. But when not fully replicating an index, there is a greater risk that actual returns will deviate from the actual benchmark or a portfolio using full replication.
This is known as the index fund’s tracking error.
Tracking error is not a one way street. It can also result in a fund achieving higher gross returns than the benchmark.
An advantage of partial replication is that by owning fewer securities, there is less trading (and transaction costs, administration expenses, triggering of capital gains, etc.) than under full replication.
Whether partial replication is preferable to full depends on the quality of the sampling technique.
Synthetic Replication
Whereas full or partial replication requires the fund to own all or some of the benchmark index holdings, synthetic replication does not.
Synthetic replication uses financial instruments to replicate the index performance. These may include the use of futures, swaps, and other derivatives.
An advantage of synthetic replication is that it is usually easier and more cost-effective to re-create and manage the benchmark using financial instruments rather than investing in individual securities.
There still may be some tracking error in performance depending on the specific benchmark index and the availability of financial instruments. For established markets though, tracking error should be small.
A potential problem arises for less established markets where finding an exact match of financial instruments is not simple. In these instances, the fund may need to rely on a less than perfect fit in trying to replicate the market. This will increase tracking errors.
Also, it may require the fund to enter into swaps with other entities to replicate the benchmark index. This creates counterparty risk (risk that one side of the transaction will not fulfill its obligations) and can impact fund performance should the counterparty default.
While trading and administrative costs are reduced with no actual securities being owned, there are still costs associated with a synthetic strategy. These include fees associated with the financial instruments used. In established markets, there are many options for replication, so the costs tend to be reasonable. But in less established markets, it may not be as easy to find replication solutions and the costs will rise.
It is not imperative that you memorize the mechanics of fund construction. It is simply a reality of index funds.
But always keep in mind that a passive investment may not exactly match the return of the market it represents. And the reasons for that lie (mainly) in the above points.
After the last few posts, hopefully we now agree that passive investing is generally the best route for individuals investing over the long term. But what should you consider when utilizing passive management in your portfolio?
There are three keys to passive investing. We shall expand on the following over the next little while.
Minimize Investment Costs
You need to ensure that your transaction and annual expenses are as low as possible.
Cost control is extremely important for investment success. And it is critical in a passive approach to investing.
We have already considered the impact of costs on performance in some detail.
It is difficult to discuss taxes in a blog with readers from around the world. But for those who do not reside in tax havens, taxes greatly impact long term investment performance.
I suggest you spend a little time understanding the investment tax laws in the jurisdictions applicable to you.
Often interest income is taxed differently than dividends. Capital gains may not be fully included in taxable income or be subject to yet a third different tax rate. In different jurisdictions, the ability to apply capital losses to past or future years may also vary.
Some jurisdictions offer tax deferred investment accounts. It is well worth one’s time to know what is available and to properly utilize such schemes to maximize compounding of current returns and to delay tax payments as long as possible.
Match Benchmark Return
The point of passive investing is not to try and beat the market, only to match it.
You want to ensure that your returns match the benchmark index as closely as possible.
Not all index funds are created equally. Depending on the fund and its mechanics, actual results can vary materially from the benchmark index. Even under a passive approach.
Funds may be created using full, partial, or synthetic replication. Each method has some potential advantages and disadvantages. We will briefly review each system in a future post.
There may be tracking errors based on how well a fund can re-create the benchmark index. The greater the tracking error, the greater the deviation from the benchmark return.
As well, index funds incur costs in operating the fund. The benchmark index has no costs to reduce returns. This also negatively impacts fund performance versus the benchmark.
As a result of tracking errors and internal operating costs, the net return for an index fund may materially differ from that of the benchmark.
Make certain that you do not assume that an index fund is an index fund is an index fund. As with any investment, do your due diligence and attempt to find funds that have closely matched the benchmark over previous years.
Tailor To Personal Investment Objectives
Ensure that you choose appropriate passive investments to meet your investment objectives.
This refers to two different things.
First, what investments should you include in a passive portfolio.
For most investors, this usually means the use of low-cost index mutual funds or exchange traded funds. For a few investors, derivatives and other financial instruments may also be used to create a passive portfolio. Our focus at this time will exclude more advanced tactics.
We have discussed mutual funds previously in some depth. I will add a separate post specifically on index funds.
We have not yet reviewed exchange traded funds. We will do so shortly.
Second, this refers to how you divide up your investment capital.
Many studies conclude that one’s asset allocation is the prime factor in determining portfolio performance. So it is a very important topic.
We will look at this in detail when we cover asset allocation.
We will also cover how to determine your investment objectives and personal constraints when we look at investment policy statements.
Sometimes objectives and constraints are not as clear as one may think. Further, as one’s personal circumstances change over time, one’s objectives and constraints also change.
So that is what we will cover over the next while.