Should You Put Your Money In Active Or Passive Investing?
Glacier by Sanlam’s Shawn Phillips makes an argument for and against both active and passive investing, saying it’s not either / or.
Published: Sunday, March 12th 2017
Passive investments in South Africa have gained popularity over the past few years. Mainly due to their low fees and tax efficiency. Previously, there were a only a few players advocating for the model that aims to match the market, and not beat it. Now, a number of the bigger fish have either jumped on, or over, the fence from the traditional active approach to the passive investing model, or both.
Shawn Phillips, Research and Investment Analyst at Glacier by Sanlam, revisits the debate between active and passive investing.
Active Versus Passive Investing
Phillips notes the premise of active investing is that skilled, and pricey, fund managers can identify profitable opportunities in the market and fetch higher returns. Passive investing, however, tracks or replicates an index, like the JSE Top 40 as an example, without attempting to beat it.
“Active investing includes high management fees and analytical costs,” says Phillips. He explains that it may not compensate investors. When comparing the net returns (after management fees are subtracted) of the active investment relative to the respective benchmark returns.
He notes that, according to the University of California, Berkeley’s, Klemens Kremnitzer, this paradigm has given rise to the burgeoning industry of passively managed funds.
“Passive management over the last couple of years has proven a viable strategy, … [and] has placed a greater emphasis on low transaction costs and tax efficiency,” noted Phillips.
Phillips argues that both active and passive management have their own relative strengths and weaknesses. “This is all dependent on the market segment as well as the economic environment,” he adds. He says it is for this reason a narrow focus on the arguments for and against the outperformance of active and passive management is required.
Phillips: "Active investing places an emphasis on buying and selling (actively investing in equities, bonds, or property) with the objective of exploiting profitable market conditions. Active managers rely on methods such as fundamental and quantitative analysis, shareholder activism, technological edge, and a superior understanding of the macroeconomic or geopolitical developments in order to generate positive returns".
Arguments For Active Management Outperforming
Phillips: "One of the main arguments for active management is based on how well informed investors are. This argument states that investors who are poorly informed remain in poorly performing funds. While well-informed investors capitalise and move into better performing funds, [...] allowing active investing to outperform passive investing. But, only for those investors who are well-informed.
Financial markets, today, are complex and very different from those a couple years ago. ... As a result, there may be an important role for active managers, even beyond the scope of the EMH*. This role, [...] involves risk management. Where active managers are cognisant of how much risk they are taking on to achieve a certain level of return.
In addition, active managers might be able to exploit what promises to be a different and a more complex economic and investment environment".
Arguments Against Active Management Outperforming
Phillips: "Due to the underperformance of active managers relative to their passive alternatives, active managers have been and will continue to be, under pressure to deliver superior returns that justify their high management fees and transaction costs. ... This has resulted in a radical change in terms of the way money has been invested. Where active managers are fearful of missing out on the top performing securities or sectors.
There is this realisation that, by simply following the herd, active managers potentially expose their investors to excessive and substantial risks. ... Furthermore, when active managers perform poorly as a result of following the herd, they tend to cling to their respective benchmarks. This guarantees mediocre returns at best".
Phillips: "Passive management attempts to replicate an index, or hold the market capitalisation of a certain number of stocks. Where the investor has no specific view of the future risk or return prospects. Moreover, passive investing has gained market share in the investment world, where the long-term results have favoured this strategy. According to the EMH*, if markets are efficient, then it is impossible for active managers to outperform an index.
Low transaction costs, tax efficiency, and a low turnover of stocks allows passive investing to outperform active investing".
Arguments For Passive Management Outperforming
Phillips: "The crux of the argument for passive investing outperforming active investing is based on low transaction costs and management fees. Management fees are an inescapable fact of investing, where passive management has lower fees relative to active management.
Actively managed funds that perform relatively well usually involve high transaction costs and high management fees. [This] implies that the outperformance is wiped out once the respective fees are deducted. As a result, the investor cannot benefit from selecting an active manager".
Arguments Against Passive Management Outperforming
Phillips: "The process involved when constructing a passive investment strategy fails to consider the investors’ investment style as well as their risk appetite. ... The level of diversification (in an index) can be much lower than expected. Whereby the performance could be driven by relatively few companies. ... This implies that passive indexes can actually have their own market-related bets and biases. Such as concentration risk to specific sectors or companies.
Despite the fact that passive investing is favourable when [...] trends of size and price momentum hold, the approach could lead to greater volatility and sharper reversals. Once the size and momentum factors dissipate. Furthermore, it is important to realise that passive investing can never outperform an index. This is purely due to the construction of an index, as it is does not cost anything to replicate it".
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Phillips: "Ultimately, the decision of whether to invest with an active or passive manager lies in one’s view on market efficiency. For the past few years, the JSE All-Share Index (ALSI) has trended upwards. But, towards the end of 2014 up until the end of 2016, the ALSI has trended sideways.
As with most things in life, the ideal lies somewhere between two extremes. In an upward trending market, passive investing should perform well. But, in a downward and sideways trending market, one would want to select an active manager with the hopes of creating superior returns.
The idea is to select active managers that the investor has a high conviction in. Where the investor buys into the respective manager’s philosophy, investment process and experience. And then, couple this with a few passive alternatives to create a long-term investment strategy…"
*Central to the notion of Modern Portfolio Theory (MPT) is this belief that markets are efficient (efficient market hypothesis or EMH) and that the average active managers are incapable of outperforming passive managers.