Passive fund performance versus active

[Shelford]

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

[BarrenWuffett]

No answer to this really. The case has been made for and against tracker funds often and loud. I can see the point, especially for the USA markets. I do not hold any trackers and never have. I've always been happy with my funds choices once I got the hang of it. I can't guarantee I'll beat an index, but I'll have a jolly good go at it.

At the end of the day, it's all about costs and the simple fact is that index funds from the likes of Vanguard are much cheaper than managed funds and investment trusts.

Another factor is personality - Tim Hale points out in 'Smarter Investing' that we all like to think we are a better than average driver- but not everyone can be better than average. Human nature drives us to compete with others, to succeed, and to be better than average. Investors try to get a better than average return and often select funds which promise to provide this.

However, the markets are very efficient. All the empirical evidence over decades shows that beating the market consistently after costs through skill is very difficult. The fund managers who can do this are rare and are very difficult to identify in advance.

It is a mathematical certainty that the market will beat the average fund manager after costs.

I have a foot in both camps - I still hold the likes of Scottish Mortgage, City of London and Finsbury Growth & Income but the larger portion of my portfolio has been switched to the Vanguard Lifestrategy 60 fund.

[hiriskpaul]

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 think there are multiple reasons. For a start, for the people who do not know of the research and arguments (or do not properly understand it), the natural instinct is to look at what has performed better recently and buy into that. At any point in time there will always be funds that have recent index beating performance for people to put their money into. For someone unfamiliar with the research and arguments, this can be very hard to grasp as it is so unintuitive. People are used to getting better outcomes by paying experts and the fact that it does not seem to work in fund management is very hard to accept and understand. For example, it would seem obvious (but wrong) to many people that an easy way to beat the index would be to simply not put money into companies that are no good. Any fund manager that does that should beat the index.

Mainstream media money rarely mentions any of the research and arguments as it is not in their interests to do so. A world where the research is widely accepted is one that does not require fund picking experts. For many it will also be dull reading as people prize the entertainment value of fortune tellers. In addition, asset management firms, etc. are hardly going to want to place adverts in media which sends out a message that their products and services are largely redundant.

For those who are aware and fully understand what the research and arguments are saying, there are still reasons why some might want to invest in active funds. An example is the psychological trait that people like to buy into dreams, such as a big win on the lottery or premium bonds. Actively managed funds provide a mechanism to fulfill this dream requirement. A small minority of actively managed funds have in the past massively outperformed their benchmarks and for some people the dream of picking such funds outweighs the fact that it is unlikely.

Another reason is that actively managed funds have the ability to take on much more risk than the market as a whole, for example through concentrated/risky portfolios and for ITs and hedge funds, through gearing. This extra risk taking certainly can produce results, but of course can also backfire and end very badly. Actively managed funds provide a simple mechanism for investors to take more risk than the market as a whole, although to a degree, ETFs can also provide a way to take bigger risks. A lot of so-called passive ETFs are really just another way to do active management.

[Hariseldon58]

If a group of active managers , who were competent and minded to minimise costs , both management fee and turnover , they would probably provide returns about the same as passive funds that were fishing in the same pool, as a whole.

The maths suggest it is very likely, so our complaint should not be that active managers are no good as a whole, ( they are the market by and large) but that they charge fees that are too high.

As a passive fund holder there is still a place for investment trusts in my portfolio on occasions, when they are mispriced. You can get a double whammy of buying an unloved asset ( contrarian purchases do outperform over time) and get a discount, which can more than compensate for the higher running costs.

It's very easy to have a binary view on passive vs active when a less dogmatic stance lets you take advantage of both.

[Alaric]

For example, it would seem obvious (but wrong) to many people that an easy way to beat the index would be to simply not put money into companies that are no good. Any fund manager that does that should beat the index.

Why is that wrong? If you have insider knowledge, that's "cheating" but you should be able to out perform. So use legitimate insider knowledge, such as analysing accounts to spot the window dressing with the hope that events or the market might eventually catch up.

[GeoffF100]

So use legitimate insider knowledge, such as analysing accounts to spot the window dressing with the hope that events or the market might eventually catch up.

Accounts are not insider knowledge, they are public knowledge, and have already been scrutinised by countless investors far more knowledgeable than you or I, and are already reflected in the price.

[saechunu]

Surely no one really believes in the strong variants of the EMH, that of perfect efficiency.

I am somewhat influenced by my own empirical observations over my investing lifetime to-date as literally the majority of my own money was garnered by exploiting imperfect markets: arising largely from situations that had been overlooked or not well analysed, leading to significant mispricings, or from situations where behavioural biases led to overreactions or anchoring, leading again to significant exploitable mispricings.

In The Long And The Short Of It, John Kay uses an interesting phrase when referring to EMH, random walk theory and CAPM: "illuminating but not true", which I think sums it up nicely. Markets are often efficient, but imperfectly so. Treating insightful models as infallible holy scripture seems not very sensible.

[77ss]

So use legitimate insider knowledge, such as analysing accounts to spot the window dressing with the hope that events or the market might eventually catch up.

Accounts are not insider knowledge, they are public knowledge, and have already been scrutinised by countless investors far more knowledgeable than you or I, and are already reflected in the price.

Accounts, maybe. But accounts are only part of the story.

The consequences of non-account events can be open to wildly different interpretations/judgements.

Brexit, US elections, takeover bids, legal actions.......

I think the efficient market hypothesis is poppycock - in the short to medium term. Remember the adage:

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

[Arborbridge]

Surely no one really believes in the strong variants of the EMH, that of perfect efficiency.

Well, the EMH on Star Trek Voyager certainly thought of himself that way

[SalvorHardin]

A few reasons why I use investment trusts (I don’t use any other type of fund and the vast majority of my portfolio is in operating company shares):

1) You can usually buy investment trusts at a discount to the NAV, so you get more income for your money. In contrast passive funds are priced at NAV (or very close to it). Should the discount narrow you will get much better performance than in a passive fund.

2) Some investment trusts have low annual management charges. For example, Law Debenture’s managers charge 0.3% which is less than quite a few passive funds (Law Debenture also has a wholly-owned fiduciary services business which gives the dividend quite a boost and is impossible for a passive fund to match).

3) Passive funds can’t properly track Private Equity investments; instead they buy shares in private equity management and ownership companies.

4) Passive funds are often forced to buy assets at stupid prices simply because they are in their benchmark. I’m particularly thinking about the dotcom trash of the late 1990s which was akin to burning money and those former Soviet Union resource companies with abysmal corporate governance which once forced their way into the FTSE100.

5) Investment trusts offer share certificates and thus non-nominee holdings. In contrast many funds have to be held via nominees and platforms, etc. which can increase your costs. I prefer to keep some of my portfolio registered with myself being both the legal and beneficial owner.

[hiriskpaul]

So use legitimate insider knowledge, such as analysing accounts to spot the window dressing with the hope that events or the market might eventually catch up.

Accounts are not insider knowledge, they are public knowledge, and have already been scrutinised by countless investors far more knowledgeable than you or I, and are already reflected in the price.

Accounts, maybe. But accounts are only part of the story.

The consequences of non-account events can be open to wildly different interpretations/judgements.

Brexit, US elections, takeover bids, legal actions.......

I think the efficient market hypothesis is poppycock - in the short to medium term. Remember the adage:

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Which part of "Brexit, US elections, takeover bids, legal actions......." do professional fund managers not know about and have opinions on?

[Lootman]

I do not hold any trackers and never have. I've always been happy with my funds choices once I got the hang of it. I can't guarantee I'll beat an index, but I'll have a jolly good go at it.

I think that many investors manage to simultaneously believe both that most active investors under-perform and that they personally have a decent shot at succeeding. Part of that is the "80% of drivers believe that they are a better than average driver" syndrome which is near universal.

But another part of it is how we are educated. We are raised to believe that if only we study hard, work hard and apply ourselves diligently, then we will succeed. And in life in general, that's true. But in investing, it often frustratingly isn't true. You can spend 40 hours a week studying the markets, have an IQ of 125, have access to research and analysis, and then still under-perform. And that is a hard pill to swallow - the idea that you do your best and still fail.

I've been investing for 30 years and have pretty much come full circle. For the most part I don't believe that I can consistently beat the markets, at least not after costs, and so the core of my portfolio is passive. But I also can't resist playing around at the edges and seeking alpha. In particular, I run a US growth strategy and trade options frequently. But it's ultimately because I think it's fun, not because I think that I'm so good at it that it buys me a better lifestyle.

In a way, the most important thing is the avoidance of obvious errors, like buying high-priced funds, chasing hot sectors and not falling for scams. Beyond that go active because you enjoy it and learn from it, not because you think you're an investing genius, because you almost certainly are not. And even if you are, so are the professionals you are competing with, and they have more money, better resources and can act faster than you can.

[hiriskpaul]

If a group of active managers , who were competent and minded to minimise costs , both management fee and turnover , they would probably provide returns about the same as passive funds that were fishing in the same pool, as a whole.

The maths suggest it is very likely, so our complaint should not be that active managers are no good as a whole, ( they are the market by and large) but that they charge fees that are too high.

This is the crux of the problem for fund managers. The main markets, aside from the whole of market passive investments, are dominated by professional fund managers and their only source of return is that of the market. If there was a large segment of poorly managed money, such as incompetent private investors/day traders, then that might be different, but increasingly that is not the case. So en masse, the actively managed funds available to retail investors can be expected to perform inline with the market before costs. If their costs can be slashed closer to that of the trackers then their long term performance should improve. There are definitely signs of that happening. The FT article mentions Capital, but Vanguard are also big in efficiently run, low cost actively managed funds.

As a passive fund holder there is still a place for investment trusts in my portfolio on occasions, when they are mispriced. You can get a double whammy of buying an unloved asset ( contrarian purchases do outperform over time) and get a discount, which can more than compensate for the higher running costs.

It's very easy to have a binary view on passive vs active when a less dogmatic stance lets you take advantage of both.

Agree about ITs. An IT returning 4% of NAV to investors through dividends and buy-backs but running on a 10% discount effectively delivers another 44bps to investors, which can make a sizable dent or eliminate the IT running costs.

[tjh290633]

Agree about ITs. An IT returning 4% of NAV to investors through dividends and buy-backs but running on a 10% discount effectively delivers another 44bps to investors, which can make a sizable dent or eliminate the IT running costs.

Buybacks are surely made by ITs as a means of trying to control the discount.

I fail to see how this returns NAV to investors, when they are using NAV reduction to make the buybacks. The only way to return more to investors is to use the money spent to increase the dividend, which of itself is likely to reduce the discount.

Have you noticed that it is ITs with higher yields that trade at a premium?

TJH

[hiriskpaul]

Agree about ITs. An IT returning 4% of NAV to investors through dividends and buy-backs but running on a 10% discount effectively delivers another 44bps to investors, which can make a sizable dent or eliminate the IT running costs.

Buybacks are surely made by ITs as a means of trying to control the discount.

I fail to see how this returns NAV to investors, when they are using NAV reduction to make the buybacks. The only way to return more to investors is to use the money spent to increase the dividend, which of itself is likely to reduce the discount.

Have you noticed that it is ITs with higher yields that trade at a premium?

TJH

If shares are bought back at a discount to NAV that reduces the number of shares and so gives existing shareholders a bigger share of the remaining pie, but because the shares were bought at a discount, this boosts shareholder value. As an example, consider an IT with 100m shares in issue, NAV per share of 100p, total value £100m, of which £900k is available for distribution to shareholders. IT buys back 1m shares at 90p, total spend £900k. Company value now £99.1m, but there are now only 99m shares in issue, so NAV per share is now 0.101p per share more than before. If you had 1000 shares, your share of the underlying assets are now worth about £1.01 more than before the buy back.

Instead of doing a buy back, the IT could have handed over 0.9p per share as a dividend (a 1% dividend if the shares are trading at 90p). That would have reduced NAV per share to 99.1p so the shareholder is no better off than before in terms of assets. However if the 0.9p is reinvested in more shares at a discount, this again boosts total value. e.g. if reinvested at 90p, that gets 1 share per 100 already held. Someone with 1000 shares would then have 1010. The NAV is 99.1p, so total value £1,000.91, or 91p more than before the dividend.

Shareholders in an IT trading at a discount benefit from the discount on both receiving dividends and from share buy backs. The main advantages of a share buy back is that it has no tax implications for shareholders and does not involve potentially more expensive reinvestment costs that shareholders might pay. The disadvantage for some shareholders is that they don't have the cash to spend or reinvest elsewhere and have to sell shares if they want to realise what would otherwise have been distributed.

[77ss]

Accounts are not insider knowledge, they are public knowledge, and have already been scrutinised by countless investors far more knowledgeable than you or I, and are already reflected in the price.

Accounts, maybe. But accounts are only part of the story.

The consequences of non-account events can be open to wildly different interpretations/judgements.

Brexit, US elections, takeover bids, legal actions.......

I think the efficient market hypothesis is poppycock - in the short to medium term. Remember the adage:

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”

Which part of "Brexit, US elections, takeover bids, legal actions......." do professional fund managers not know about and have opinions on?

Do you genuinely see no difference between opinions formed on the basis of published accounts and opinions about events that may not yet have happened or whose consequences/outcomes are still unclear?

[hiriskpaul]

Do you genuinely see no difference between opinions formed on the basis of published accounts and opinions about events that may not yet have happened or whose consequences/outcomes are still unclear?

Not sure what your point is. The same information (and lack of) should in theory be available to all investors. If you think you can make better than average investment decisions based on the information available to you then good for you.

[77ss]

Do you genuinely see no difference between opinions formed on the basis of published accounts and opinions about events that may not yet have happened or whose consequences/outcomes are still unclear?

Not sure what your point is. The same information (and lack of) should in theory be available to all investors. If you think you can make better than average investment decisions based on the information available to you then good for you.

You need to read my original post in context, As a response to GeoffF100's comment: Accounts are not insider knowledge, they are public knowledge, and have already been scrutinised by countless investors far more knowledgeable than you or I, and are already reflected in the price.

I was pointing out that market judgements based on public knowledge are not the whole story and that market judgements based on opinion can vary enormously - and be wildly wrong - the underlying point being that in a number of cases solid information is quite simply lacking. For recent examples, you only have to look at the deep falls in some shares following the unexpected Brexit result. Since followed by equally steep recoveries.

[Alaric]

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?

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.

[hiriskpaul]

Do you genuinely see no difference between opinions formed on the basis of published accounts and opinions about events that may not yet have happened or whose consequences/outcomes are still unclear?

Not sure what your point is. The same information (and lack of) should in theory be available to all investors. If you think you can make better than average investment decisions based on the information available to you then good for you.

You need to read my original post in context, As a response to GeoffF100's comment: Accounts are not insider knowledge, they are public knowledge, and have already been scrutinised by countless investors far more knowledgeable than you or I, and are already reflected in the price.

I was pointing out that market judgements based on public knowledge are not the whole story and that market judgements based on opinion can vary enormously - and be wildly wrong - the underlying point being that in a number of cases solid information is quite simply lacking. For recent examples, you only have to look at the deep falls in some shares following the unexpected Brexit result. Since followed by equally steep recoveries.

If your point is that things other than published accounts affect share prices, then I completely agree. I very much doubt that was what GeoffF100 was implying.