Passive fund performance versus active

[hiriskpaul]

If you think you can make better than average investment decisions based on the information available to you then good for you.

The underlying premise should be easy enough to understand. Take an index, say the FTSE 100. That's computed by following the performance of 100 share prices with the index computed by weighting by market capitalisation. You can construct an investment portfolio by buying stocks in proportion to their weights in the index. Something you also know from past experience is that future changes in market prices are not going to be uniform. Some will outperform the index whilst others will under-perform. If by some means of divination you could identify the out performers or the under performers, then you could out perform the index by only investing in selected stocks. You would increase your risk against the index by doing this, but why not?

A good description of what active fund managers set out to do. Not sure what your point is though.

I don't think accounts are such an exact science that two independent teams of accountants would produce identical accounts from the same basic facts, so there has to be scope for research in this area to see which companies have presented accounts which have used permitted methods to mask potential problems, or from the other direction, are unduly pessimistic.

I would agree with this. Of course different opinions matter and collectively active fund managers, it is mostly the active fund managers actions that matter, will through a process of supply and demand, determine share prices, hence index weights. Passive investors (full market cap weighted passive investors at least) freeload on the back of the research and opinions of the active fund managers. The annoyance of active fund managers is justifiable.

[OhNoNotimAgain]

A good balanced article in the FT today about the performance of active funds versus passive, in the context of Capital performance (the second largest asset manager in USA after Vanguard).

Once again, proof that over a sensible time period for evaluating equity performance (viz 10 years), active fund managers fail to prove their worth. According to the article, 87.5% of US equity funds failed to outperform their index over past decade.

https://www.ft.com/content/5e1df770-0d58-11e7-a88c-50ba212dce4d (note you have to register)

The question once again is: if only 2 out of 10 active fund managers (at best) manage to succeed in beating the index, why does anyone bother to invest in active funds, when the likelihood of you choosing an outperformer is so low?

I'm preaching to the converted here of course

Shelford

How can it be balanced when the paper devotes a whole page to an active manager. When was the last time it did that for a passive manager?
Rob

[mc2fool]

How can it be balanced when the paper devotes a whole page to an active manager. When was the last time it did that for a passive manager?

A passive manager? Wot, an Excel spreadsheet? Once set up a trained monkey could run a passive fund. There's no subjective or judgement decisions to be made, that's the point, isn't it? In fact I'll bet that the vast majority of passives are run by computers. How many individual passive managers can you name?

[0x3F]

Many bright folk that I follow are talking about a market bubble driven by etfs. Probably talking their own book I suppose, but their arguments are persuasive.

They point out that now etfs make up such a large portion of the market, they in effect are the market and it becomes about flows of money which are used to blindly buy the index. No value decision is made as to whether a stock is cheap/expensive, they are just bought in the correct proportion. Expensive stocks get even more expensive. This is akin to a momentum strategy and as more money comes in, the index climbs higher and higher, helped Along by trend following algos.

The arguement for active, which have clearly underperformed , is that as the market is no longer as efficent since etfs don't evaluate risk/reward which will give opportunities to exploit. Additionally, they worry about lack of liquidity causing an 87 type event as when it turns and this wall of etf money (opposite momentum!) tries to pull out at the same time, there will be few buyers which will lead to very large falls, very quickly.

I'm happy to continue holding my underperforming multi asset ITs, where the managers are free to hold any asset class that they think exhibit the best value.

0x3F

[hiriskpaul]

Many bright folk that I follow are talking about a market bubble driven by etfs. Probably talking their own book I suppose, but their arguments are persuasive.

They point out that now etfs make up such a large portion of the market, they in effect are the market and it becomes about flows of money which are used to blindly buy the index. No value decision is made as to whether a stock is cheap/expensive, they are just bought in the correct proportion. Expensive stocks get even more expensive. This is akin to a momentum strategy and as more money comes in, the index climbs higher and higher, helped Along by trend following algos.

The arguement for active, which have clearly underperformed , is that as the market is no longer as efficent since etfs don't evaluate risk/reward which will give opportunities to exploit. Additionally, they worry about lack of liquidity causing an 87 type event as when it turns and this wall of etf money (opposite momentum!) tries to pull out at the same time, there will be few buyers which will lead to very large falls, very quickly.

No doubt these bright folk are all underweight or short all these expensive stocks then? Good for them when their prophecies come to pass.

I'm happy to continue holding my underperforming multi asset ITs, where the managers are free to hold any asset class that they think exhibit the best value.

0x3F

Which multi asset ITs?

[hiriskpaul]

Could I just pose the obvious question then - If everybody used a tracker fund, how would the market operate? There would be no market to track, would there?

If you read 0x3f's posting you will get some clues as to why this will not happen.

[0x3F]

No doubt these bright folk are all underweight or short all these expensive stocks then? Good for them when their prophecies come to pass.

I did say they were talking their own book . Funny you should mention about when their prophecies will occur - yesterday I saw a quote from 1975 WSJ saying much the same as I stated above. Indexing a much larger part of the market now, of course.

Which multi asset ITs?

The usual crowd: Personal assets, Ruffer, etc. I say under performed, I'd expect them to under perform in rising markets as not 100% equity, and so need to be evaluated over the full market cycle. I guess another option might be to set up an allocation using ETFs covering different asset classses, though I'm not sure what the optimal allocations are.

0x3F

[hiriskpaul]

The usual crowd: Personal assets, Ruffer, etc. I say under performed, I'd expect them to under perform in rising markets as not 100% equity, and so need to be evaluated over the full market cycle. I guess another option might be to set up an allocation using ETFs covering different asset classses, though I'm not sure what the optimal allocations are.

0x3F

I am not familiar with the usual crowd, but multi-asset funds are available to passive investors as well. A good example are Vanguard Lifestrategy funds. For example the LS 60 passively mixes 60% in global equities with 40% global fixed income. Over the last 5 years to end Feb that has delivered a total return of 58%, beating 10 out of 15 ITs in the Flexible Investment sector with 5 year histories. It did not exist during the financial crisis, but it is possible to get some idea of how it would have performed by combing the returns of a global equity index with that of gilts. During 2008, the MSCI global equity index would have lost about 17% (as measured in pounds), including re-invested dividends, but gilts would have gained about 13% (including re-invested interest). So a 60/40 combination would have only lost about 5%. Perhaps some of these ITs would have done better. I don't know and am not inclined to find out.

The range of returns of ITs (4.6% to 133.1% in the Flexible Investment sector) does illustrate the major problem I have with active management. The range of outcomes over a period of only 5 years illustrates the large additional risk being taken backing active managers. Now I am not at all against taking additional risks, but I am only prepared to do so with an expectation of a higher payoff compared with not taking the risk. I might not get the additional return, but the expected value of the additional return should be positive. The problem with active management, as indicated in the OP and a from a purely logical consideration over higher fees, is that the expected additional return from actively managed funds is negative, not positive. Other than the thrill of a punt, which I mentioned earlier as a possible reason to invest, why would I want to take on additional risk when the expected return on that additional risk is negative?

(I still buy ITs by the way, but only when I can get them at a decent discount to NAV).

[Kantwebefriends]

If you think you can make better than average investment decisions based on the information available to you then good for you.

I would hope that I can make better decisions for my particular case than the average investment manager, or tracker computer, can. But that means not that I know more about the markets, but more about me.

[saechunu]

Meeting your investment goals should be the primary concern of any investor, with finding an approach, or approaches, that suit being the key. If you desire the cachet of never underperforming an index you can simply create your own index that mirrors your own portfolio as is increasingly de rigeur.

In any case, Paul is not so religious as he may sound - he actively manages most of his portfolio. Nothing wrong with that, if that works for you (or him), per my initial sentence. Self-managing can actually prove very low-cost, which is highly desirable, although clearly this depends on the strategy employed.

[foxy]

If you think you can make better than average investment decisions based on the information available to you then good for you.

I would hope that I can make better decisions for my particular case than the average investment manager, or tracker computer, can. But that means not that I know more about the markets, but more about me.

Thank you for taking the time to inform us of your above averageness and self discovery.

[GeoffF100]

They point out that now etfs make up such a large portion of the market, they in effect are the market and it becomes about flows of money which are used to blindly buy the index. No value decision is made as to whether a stock is cheap/expensive, they are just bought in the correct proportion. Expensive stocks get even more expensive. This is akin to a momentum strategy and as more money comes in, the index climbs higher and higher, helped Along by trend following algos.

This is a complete misunderstanding. The whole point of market weighted trackers is that you do not distort the market by buying them. Indeed, if everyone has the same objectives, their optimum portfolio must be the same, and the market portfolio is the only portfolio that they can all hold, so it must be optimal.

[OhNoNotimAgain]

They point out that now etfs make up such a large portion of the market, they in effect are the market and it becomes about flows of money which are used to blindly buy the index. No value decision is made as to whether a stock is cheap/expensive, they are just bought in the correct proportion. Expensive stocks get even more expensive. This is akin to a momentum strategy and as more money comes in, the index climbs higher and higher, helped Along by trend following algos.

This is a complete misunderstanding. The whole point of market weighted trackers is that you do not distort the market by buying them. Indeed, if everyone has the same objectives, their optimum portfolio must be the same, and the market portfolio is the only portfolio that they can all hold, so it must be optimal.

Of course they do. New money goes into the largest mkt caps and as they get bigger they attract a larger percentage of new flows. It takes a brave man or a innovative (i.e. smart-beta) approach to put new money into stocks that are getting cheaper.

When you go to the supermarket do you buy more that stuff that has gone up in price or more stuff that has been discounted? It is a bizare fact of life that investors do the opposite when it comes to buying shares or funds.



Rob

[Alaric]

The whole point of market weighted trackers is that you do not distort the market by buying them.

If there are no active traders or investors, how is there a market? A company announces poor results. Active investors sell their holdings and the price falls. How does the price fall if there are no investors prepared to depart from the portfolio implied by the construction of the index?

[0x3F]

This is a complete misunderstanding. The whole point of market weighted trackers is that you do not distort the market by buying them.

No, the whole point of market weighted trackers is to track the market.

I read that the end of day trading volume is an order of magnitude higher than that during the rest of the day, caused by ETFs re-balancing their portfolios - how can that not distort the market?

0x3F

[0x3F]

For example the LS 60 passively mixes 60% in global equities with 40% global fixed income. Over the last 5 years to end Feb that has delivered a total return of 58%, beating 10 out of 15 ITs in the Flexible Investment sector with 5 year histories. It did not exist during the financial crisis, but it is possible to get some idea of how it would have performed by combing the returns of a global equity index with that of gilts.

Though I do find it interesting, I'd be careful about comparing the past performance of the LS 60 and expecting similar. With interest rates at historic lows, I think its important to consider the duration of the bond component of that fund and how it might react should they normalise.

My worry is that in the next crisis the usual (inverse) bond/equity correlations may not apply and both could fall. FWIW the 'bright' folk I follow very much think (US) interest rates are going to keep falling.

The range of returns of ITs (4.6% to 133.1% in the Flexible Investment sector) does illustrate the major problem I have with active management. The range of outcomes over a period of only 5 years illustrates the large additional risk being taken backing active managers.

I'm not convinced about that sector classification as a whole but take your point the collective performance isn't good (it contains companies that have only recently converted to multi asset for example, others that are nearly 100% equity, and so I think you need to pick from it).

I'm focused on achieving the best return for the lowest risk, which sounds similar to what you're doing. It's possible to select companies in that sector which have 20+ year track records of outperforming the market with less risk. Measures of risk for these companies, such as Sharpe ratio, are comparable to those of the LS 60 funds. The main attraction is multiple asset classes (not just bonds/equity) and also that they appear to be wary of interest rates too and have a low weighting in longer duration.

All the best,
0x3F

[hiriskpaul]

They point out that now etfs make up such a large portion of the market, they in effect are the market and it becomes about flows of money which are used to blindly buy the index. No value decision is made as to whether a stock is cheap/expensive, they are just bought in the correct proportion. Expensive stocks get even more expensive. This is akin to a momentum strategy and as more money comes in, the index climbs higher and higher, helped Along by trend following algos.

This is a complete misunderstanding. The whole point of market weighted trackers is that you do not distort the market by buying them. Indeed, if everyone has the same objectives, their optimum portfolio must be the same, and the market portfolio is the only portfolio that they can all hold, so it must be optimal.

Of course they do. New money goes into the largest mkt caps and as they get bigger they attract a larger percentage of new flows. It takes a brave man or a innovative (i.e. smart-beta) approach to put new money into stocks that are getting cheaper.

When you go to the supermarket do you buy more that stuff that has gone up in price or more stuff that has been discounted? It is a bizare fact of life that investors do the opposite when it comes to buying shares or funds.

Rob

Anyone who buys a subset of the global market not by cap weight is distorting the market!

"Distorting" is an emotive word though. I prefer to think in terms of price pressures. If a lot of money pours into global cap weighted trackers, that will apply upward price pressure across the board, for every stock in the global index. But the price pressure will be evenly distributed. Upward price pressure will be the same for small stocks as for large stocks. But if an alternative weighting scheme was used that will cause distortions. For example high demand for an equal weight tracker will cause higher price pressure on smaller stocks than larger ones. Similarly if FTSE 250 trackers become very popular compared to the rest of the market, that will cause higher upward price pressure on FTSE 250 stocks compared to other stocks.

The so called passive funds are not a homogenous group. There are lots of cap weighted trackers, but in addition to global trackers, the market is sliced and diced into regions, countries, sectors, mega caps, big, mid and small caps. In addition to the cap weighted funds, there are those that filter for growth and value, plus a large number of alternative weighting schemes and themes such as dividend aristocrats. Anyone buying or selling any of these subsets will "distort" the market, just as active managers and private investors do.

I dispute the fact that it takes a brave man to put money into stocks that are getting cheaper, this happens all the time. Those investing in whole of market trackers do it and anyone investing in funds with a value tilt (passive or active) put proportionately more into cheaper stocks than expensive ones. Every share has to be held by someone.

[hiriskpaul]

Meeting your investment goals should be the primary concern of any investor, with finding an approach, or approaches, that suit being the key. If you desire the cachet of never underperforming an index you can simply create your own index that mirrors your own portfolio as is increasingly de rigeur.

In any case, Paul is not so religious as he may sound - he actively manages most of his portfolio. Nothing wrong with that, if that works for you (or him), per my initial sentence. Self-managing can actually prove very low-cost, which is highly desirable, although clearly this depends on the strategy employed.

Indeed, private investors do not charge themselves fees! This topic is not really about private investors though, it I is about whether it is worthwhile paying for active fund management, compared with cheap tracker funds. As far as I can see there is mounting evidence that active management it is not worth paying for across most of the global liquid equity markets. Active funds add risk for no additional risk adjusted returns. I make exceptions for things such as small caps, private equity and special situations where I think the odds might be tilted in my favour by using an active fund.

[hiriskpaul]

This is a complete misunderstanding. The whole point of market weighted trackers is that you do not distort the market by buying them.

No, the whole point of market weighted trackers is to track the market.

I read that the end of day trading volume is an order of magnitude higher than that during the rest of the day, caused by ETFs re-balancing their portfolios - how can that not distort the market?

0x3F

I cannot see how that has much to do with ETF rebalancing. Most of them only rebalance a few times each year.

[hiriskpaul]

The whole point of market weighted trackers is that you do not distort the market by buying them.

If there are no active traders or investors, how is there a market? A company announces poor results. Active investors sell their holdings and the price falls. How does the price fall if there are no investors prepared to depart from the portfolio implied by the construction of the index?

This is a straw man. There will always be active investors.