Articles
Myths and Legends: The Active vs Passive Debate
Versions of the story differ, but they boil down to the notion that in volatile markets, active managers outperform. (This industry nomenclature of "active" and "passive" is highly misleading, by the way, but more on that later.)
According to the legend, volatile market times such as these are when active managers earn their sizeable fees, as they sharpen their pencils and pick the best stocks and other assets in a falling market. Passive managers, by contrast, just ride the market all the way down.
But as a Wall Street Journal columnist observed recently, if this is a stock picker's market, the stock pickers need to start picking better stocks.
The WSJ commissioned research house Morningstar1 to assess the performers of active managers in the current economic slowdown. It found that so far in 2008, active funds had fallen below their benchmarks in six of nine major categories.
Furthermore, the survey found that the stock pickers were performing worse than in previous slowdowns, undermining their boast that they are in a better position than anyone to navigate the stormy seas of the credit crisis.
For anyone who has spent any time focusing on actual results rather than marketing spin, these findings shouldn't really be a surprise.
A University of Chicago study by Mark Carhart2 found that persistence in managers' outperformance does not reflect superior skill in stock picking, but their exposure to common factors in stock returns and their costs. Indeed, most funds underperform their benchmarks by the magnitude of their costs.
"While the popular press will no doubt continue to glamorise the best performing mutual fund managers, the mundane explanations of strategy and investment costs account for almost all of the important predictability in mutual fund returns," wrote Carhart, whose study encompassed more than three decades of data.
It's not only academics saying this, either. Until last year, Standard and Poor's published a quarterly analysis3 of the performance of active funds relative to its indices. These consistently showed that while active managers enjoy short periods of outperformance, over long periods (3-5 years), they rarely better their benchmarks.
So why does this myth of volatile markets suiting active managers persist? Part of it is due to an understandable need to believe there are people out there who have the skill to consistently beat the market.
This belief is what leads people to pay exorbitant fees to fund managers to deliver the elusive "alpha", the return above the market return attributable to individual skill. The problem is that people end up paying "alpha" fees for "beta" results—the returns the market would have given them anyway.
In a survey released earlier this year, investment consultancy Watson Wyatt4 found that superannuation and pension funds around the world are paying on average 50 per cent more in fees than they were five years ago.
"One of the main reasons for this upward cost spiral is investors' focus on alpha, which has increased their appetite for alternative assets," said Watson Wyatt's head of investment consulting in Australia, Graeme Miller.
"Investors have naturally assumed that they are paying these fees to reward manager skill, but in many cases they are wrong."
In a lower return environment, as seen recently, it was even more imperative that managers demonstrated how they were adding value, Miller said.
And this brings us back to the never-ending industry debate over "active" versus "passive". This argument over which is best—stock picking and market timing versus a long-term buy and hold approach—extends back more than three decades and is unlikely ever to be resolved.
But it would help the ordinary investor make the right decision if the financial services industry used less loaded terminology.
A supposedly "passive" manager can actually be quite active. But they are active in areas where they can actually make a difference for investors.
These include designing quantitative strategies to capture the risks that offer higher expected returns, employing qualitative assessment to filter out securities not being targeted and ensuring they implement these strategies patiently and efficiently.
That's what Dimensional does. Call it passive. Call it active. But whatever you call it, this is a disciplined asset class approach that involves no forecasting, stock picking or market timing.
Unlike the urban legends described above, this approach is based on solid theoretical grounds, is proven in the real world of day-to-day portfolio management and, most of all, works well for investors.
In the end, that's all that really matters.
1'Though Stock Pickers Struggle, Tech Stocks Revive', The Wall Street Journal, May 31, 2008
2Mark Carhart, 'On Persistence in Mutual Fund Performance', The Journal of Finance, Vol 52, No.1, March 1997
3'Standard & Poor's Indices Versus Active (SPIVA) Funds Scorecard', March quarter 2007, S&P website
4'Funds Paying over 50% More Investment Fees than Five Years Ago', Watson Wyatt, media release, Feb 28, 2008
Back