Investors need to keep an open mind when it comes to comparing active vehicles to passives, according to Schroder’s Gavin Ralston (pictured), who urged investors not to abandon active management simply because it hasn’t met expectations recently. 
In fact, research by the head of official institutions and thought leadership shows that holding actively managed vehicles as part of a wider portfolio is “critical” in order to maximise returns.
While some markets are more efficient than others, he believes it could be dangerous to abandon active funds altogether as more and more investors continue to flock to passives.
“There is a danger that, where active management has not met expectations, investors feel that they should abandon it altogether,” Ralston wrote in his latest blog post for Schroders Insights. “But closer analysis of the data suggests many investors in active equity strategies have beaten passive funds after fees.
“Investors need to use all the tools available to them: active, passive and smart beta. We would argue that the potential value added from active management remains critical to maximising the return from a broad portfolio, meaning that active management will in time start to regain share from passive.”
This follows two recent FE Trustnet articles looking at active versus passive investing. In a piece published yesterday, investment professionals discussed whether the increasing popularity of passive vehicles poses a threat to the active management industry.
Martin Bamford, managing director at Informed Choice, said: “Active fund management is under the microscope like never before, with a big case to answer to ensure investors remain prepared to accept higher costs for the opportunity, without guarantee, they could get higher returns than those on offer from the index.”
Ralston said the issue is far from clear cut. He referenced professor William Sharpe, a US economist who said that, “after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar”.
However, Ralston said this view was taken assuming that the index represented the whole range of investment opportunities and that every fund had the same objective.
He also pointed out that ultra-loose monetary policy from central banks has distorted market behaviour.
“Data from SPIVA [S&P Indices Versus Active], part of S&P Dow Jones Indices, is often used in the passive-active debate,” Ralston explained.
“A recent SPIVA report stated that over 88 per cent of large-cap equity funds in the US underperformed the S&P 500 index in the latest five-year period.
“In the case of large-cap US equities, this conclusion is reinforced from other sources, but there are weaknesses in the SPIVA methodology.
“It assumes any fund which has closed or been merged into another fund has underperformed. This assumption is not universally valid. We tested UK stock market funds that had closed in the past 10 years and found that 20 per cent had outperformed before closure.”
He argued that the US market is different because its institutions are more familiar with domestic securities than other countries and, as such, it is a more efficient market.
To analyse data across other markets, Ralston decided to use ETFs as opposed to indices as these include management fees and trading costs.
His research below found the assumption that passives will outperform active management is by no means the case, given the varied proportion of active funds outperforming their respective ETFs across different market areas.
Source: Schroders
“Drilling down further, we looked at how active performance has varied over time in the UK and emerging markets. We looked at monthly excess returns after fees – in this case against the index,” Ralston continued.
“Unlike previous studies, we included only funds that are benchmarked to a broad index. By doing so, we excluded the funds that are either not benchmarked, or funds that employ a specific strategy, such as sustainability or special situations.”
When looking at the active funds in the UK and within emerging markets which have outperformed their benchmarks over rolling five-year periods, he found performance has indeed improved over time.
While Ralston’s data shows actively managed UK funds’ performance is cyclical, he said there have been several periods since 2008 – including the present – when well over 60 per cent of active funds have outperformed net of fees.
Within emerging markets, he said the performance of actively managed funds has steadily improved since 2008.
“There is also good evidence that managers who perform well over the longer-term experience significant periods of underperformance in the short term,” Ralston reasoned.
“The Vanguard Group published a study in 2015 which showed that, of the 552 active US equity funds that had beaten the index over the previous 15 years, 98 per cent had underperformed in four or more individual years.
“The implication is that investors are more likely to achieve good outcomes if they do not abandon a strategy after a short period of underperformance.”
Ralston has also researched the debate surrounding fees of passive versus active vehicles.
He found that assuming a 0.3 per cent average annual passive fee for UK equities over a 26-year period, the passive fund will have trailed the benchmark by 8 per cent. This means that, while many active funds have indeed underperformed their benchmarks, 100 per cent of passive funds have underperformed.
“The point about measuring the real cost of passive management is most visible in emerging markets, where the costs of acquiring market exposure have been higher (until recently typically 0.75 per cent) than in developed markets,” Ralston said.
“Of course, the cost of passive has fallen significantly in the last few years, raising the standard against which active managers will be measured in future, but in many markets passive costs are still material.”
He explained that a further reason not to ditch active management is the role it plays in both the economy and society.
Without active managers, Ralston pointed out that asset prices would be based purely on the market size of companies so there would be no means to deploy capital in the best places and maximise returns for the benefit of the whole economy.
“There is already evidence that recent large flows into passive funds are leading to distortions in markets,” he said.
“We would contend that the stewardship activities of active investors raise returns in the capital markets by encouraging higher standards of corporate governance and directing capital into faster-growing industries.”