FE Trustnet News and Research

The major long-term theme passive investors can’t afford to ignore
Alex Paget
By Alex Paget  22 Jun 2016

With future returns likely to be far lower than over the previous past three decades, Seneca’s Peter Elston says passive fund enthusiasts may need to consider taking an active approach going forward.

The high likelihood that future returns from all asset classes will be lower than over the past three decades means pure passive investors need to consider some active exposure within their portfolios, according to Seneca’s Peter Elston.

The debate surrounding active versus passive funds has only intensified over recent years as there has been a greater focus on cost within the fund management industry, especially thanks to the advent of ‘smart beta’ funds and increased transparency regarding active share and tracking error in the active community.

Indeed, passive funds have witnessed significant inflows over recent years as investors have preferred to pay a low ongoing charge and remove any potential for human error when it comes to their future returns.

Certainly, taking a passive approach has worked in the UK so far in 2016 thanks to a significant rebound in some of the FTSE 100’s largest constituents following a dismal run of performance in 2015.

According to FE Analytics, while 75 per cent of active funds in the IA UK All Companies and IA UK Equity Income funds beat the FTSE All Share last year as commodity stocks had a terrible run, the reversal of that trend means just 18.3 per cent of UK active funds are ahead of the benchmark year-to-date.

Performance of UK active funds versus index in 2016


Source: FE Analytics

However, Elston – who is chief investment officer at Seneca – says investors shouldn’t necessarily bet on that outcome happening over the longer term. He says the reason for this stems from the recently published McKinsey report entitled ‘Diminishing Returns’ and the conclusions it makes.

“The thrust of the report was that investors’ current expectations for future returns have been shaped by actual returns enjoyed over the last three decades. Since these were unusually high, expectations for the future are now too high,” Elston (pictured) said.

“The report notes that high returns over the past three decades were due to sharp declines in inflation and interest rates; high GDP growth that was the result of positive demographics, productivity gains and rapid growth in China’s economy; and even stronger corporate profit growth due to such factors as declining corporate tax rates.”

“Some of these trends, the report argues, have now either stalled or gone into reverse, meaning that future returns will be lower, perhaps considerably so, than they were in the past.”

“I have sympathy with the conclusion, and in fact would add the cost of climate change to the list of factors that will increasingly impact growth – and indeed aggregate corporate profits – in the decades ahead.”

FE data shows investors have had a wealth of investment opportunities to choose from over the longer term.

The likes of UK equities, property, government bonds and corporate bonds have all delivered returns in excess of 350 per cent since 1990. Indeed, even cash (shown crudely by the IA Money Market sector average) has returned 122.99 per cent over that time.

Performance of sectors and indices since 1990


Source: FE Analytics

However, with bond yields near all-time record lows and extraordinary monetary policies from the world’s central banks distorting valuations in other asset classes, many agree with the conclusion from the McKinsey report.

Elston points out that every investor has a choice going forward: either be in the market via a passive fund and except the lower returns it is likely to deliver (albeit lower, after charges) or attempt to beat the market via an active manager (but risk significantly underperforming the market if said active manager makes the wrong calls).

“It is therefore ironic that flows into passive funds appear to be accelerating, at a time when market returns are in decline. Furthermore, if you need to make your savings pot last longer because you are going to live longer, you are effectively doubling your problem by going passive,” Elston said.

According to FE data, for example, the best-selling IA UK All Companies sector over one year has been a tracker (Vanguard FTSE UK All Share Index with inflows of £754m), while three other passives feature in the list of top 10 selling funds in the peer group over that time.

IA UK All Companies funds attracting the most money over 1yr


Source: FE Analytics  

Elston argues that investors should never blindly go for active managers over passives, adding that passive funds do have a role to play within a diversified portfolio.

However, he also takes issue with the argument that as active funds (as a group) have failed to consistently outperform entirely, investors should focus on low cost trackers for their exposure going forward.

“This is not to say that I think beating the market is straightforward. It clearly isn’t, as the plentiful evidence that most actively managed funds fail to beat their benchmark indicates,” Elston said.

“I am thus dismayed that a recent FT article noted that active managers have been ‘attacked by academics and consumer groups for not offering value for money’. Of course active managers do not as a group offer value for money.”

“The reality is that active investing is not like blackjack in which it is possible for everyone to win, but poker, in which some win necessarily at the expense of others. The above attack is the equivalent of criticising lotteries on the basis that the vast majority of participants win less (i.e. nothing) than they spend to play.”

“This analogy is not a perfect one, because winning lotteries is about luck. If financial markets were efficient, and it was thus impossible to beat the market, I can assure you my savings pot would be stuffed full of passives.”

He added: “But they’re not.”

Elston says that the price of financial assets do not move randomly. Instead, he argues that they exhibit pattern which means that price movements are a function of previous movements and are thus predictable to some extent.

Of course, there are many who would disagree with this view, but Elston says there is plenty of statistical evidence that shows patterns in financial markets is fact, rather than opinion.

“For example, when real interest rates are high, real returns from bonds will tend to be high (the converse is also true),” he said.

“Another one: when the dividend yield of a higher quality company’s stock is higher than the market average, the stock’s total return tends to be higher than the market average. (Another name for the pattern at work here is mean reversion).”

However, Elston also argues that there are reasons why investors fail to benefit from these inefficiencies. As such, in an upcoming article, he highlights the three major reasons why active funds can underperform. FE Trustnet Registration