Often the primary reason cited for underperformance is the fees that these funds charge. From this simple observation springs the common assumption that investors are better off investing in passive funds that replicate the performance of an index.
However, passive funds also charge fees. Their fees are usually significantly less than those of active funds, but they will still, on average, cause the fund to lag an index.
In addition, passive funds suffer from tracking error – the trading costs of having to change their portfolio as an index changes.
Management fees and tracking costs are usually low for a passive fund investing in a small number of large companies, but can be significant for broader indices, especially those that include small and mid cap stocks.
The investment actions of passive funds are transparent so it is easy for active funds to pre-empt them, bidding up through purchase the prices of shares that the passive funds will have to buy and depressing through sales those they will have to sell.
The bigger the share of the market taken by passive investors and the more their index changes, the greater the opportunity for active managers to add value at the expense of the passive funds.
Passive funds are also a favourite client of investment bankers, as they will always buy equity issuance, regardless of the quality of the company, its valuation or the advisory fees.
They may end up with holdings in companies such as ENRC, Bumi and Glencore, which the active funds will likely (wisely in our view) ignore.
A market based only on passive investors would exercise no discipline on companies in terms of corporate governance, profitability, financing or business strategy.
Capital would be allocated to the biggest companies, rather than those with the best risk-adjusted returns.
Without the discipline of capital allocation, market returns would be lower in the short-term, and in the longer term, capitalism would fail.
Active funds will, on average, underperform their index, but they will raise the performance of that index by imposing capital discipline on companies.
The flaw in passive investing was recently exposed in a study by the Cass Business School. It showed that "monkeys" outperform passive funds.
A computer was programmed to randomly pick and weight each stock within a 1,000-strong sample. This program, which replicated a monkey randomly choosing a portfolio, was repeated 10 million times.
Based on monthly share data from the last 40 years, it was found that nearly all of the study’s 10 million indices weighted by chance delivered vastly superior returns to the market cap approach used by conventional indices.
Enthusiasts for passive investing often admit this flaw, advocating equal-weighted indices instead.
The first problem with this is the higher tracking error and costs associated with broad passive funds investing lower down the size scale – comparatively little is invested in the large, liquid mega caps which are a permanent feature of the index.
More importantly, the universally accepted standards for indices are market capitalisation-weighted ones and that is the performance that investors target. Equally weighted indices can diverge significantly from these in both directions.
The favourite strategy of active investors seeking to beat the market is to overweight mid and small cap exposure at the expense of large cap companies.
There is ample historic and theoretical evidence that small and mid cap stocks outperform large caps in the long-term, so such a strategy should load the odds in the active manager’s favour.
Equally weighted indices beat market capitalisation-weighted ones for the same reason.
The problem is that small and mid cap stocks can lag large caps for long periods of time despite the long-term trend, so there is no guarantee that an equally weighted passive fund will outperform the standard index.
Performance of large and mid cap indices 1990 to 2000
Source: FE Analytics
For the same reason, we believe a strategy of investing in passives with a structural overweight of mid and small caps is also flawed; actively managing the split between large caps, and mid and small caps, may help – but this is not a passive strategy.
Investors can improve the odds of adding value through active managers by following some simple rules.
First, it is easier for managers to add value in some areas than others. For example, managers of funds focused on US equities or corporate bonds struggle to outperform, while small cap managers find it easier.
Investors may therefore prefer to focus their fund research on areas with consistent outperformance by active funds.
Second, basic due diligence should weed out a sufficient number of obvious poor performers to improve the odds in the bulk of the sector to comfortably better than evens.
Third, outperforming funds sometimes beat their benchmark index by wide margins; holding one of these funds will compensate for a lot of mild underperformers elsewhere in a portfolio.
The scale of out- or underperformance is as important as the frequency of it and the distribution of fund performance is not necessarily symmetrical between relative winners and losers.
Max King runs the Investec Multi Asset Protector and Managed Growth funds. The views expressed here are his own.
