ACTIVE V PASSIVE: Rarer than a unicorn’s horn

Many years after the active versus passive debate was launched, the attacks on active managers continue. Nick Fitzpatrick reports.

The ruthlessness of the attack on active fund management is rising in line with ETF popularity.

SCM Private, a London-based wealth manager that invests only in exchange-traded products, produced damning research of UK active equity managers who invest money for retail clients, claiming many managers are index huggers charging active fees.

Though the accusation is nothing new, the research had two novel aspects: its methodology; and its take-no-prisoners ferocity.

SCM, founded by Gina Miller, a scourge of the active fund management industry, measured the level of “active share” within 127 UK equity funds. Active share is a concept from Yale School of Management and denotes the percentage of a portfolio that does not mirror index weightings.

Sure enough, the research found that 40% of the average fund surveyed was not active share and mirrored the fund’s index. Further, those with the lower portion of active share were more likely to underperform, net of fees, their benchmarks than funds with a higher active share.

As for the ferocity of the attack, the press release that launched the report declared that Miller was “happy to name names” – and indeed the Closet Indexation in UK versus US Equity Funds report does.

So does this mean that investors, especially smaller investors, should jump in entirely to passive investment management?

The crux of the argument in the active versus passive debate is not that active managers never deliver outperformance and value, but that those who do provide decent alpha at a reasonable level of risk are harder to find than a unicorn’s horn. In the SCM research, there were a good number of outperformers, though perhaps it is no coincidence that the highest performer – with 29% against a 7.4% FTSE return in the same five-year period – is called Unicorn Asset Management.

The Efficient Market Hypothesis, at least in one of its expressions, forms the basis of the view that active managers are more likely to outperform in markets that are less efficient, typically meaning where there is less information.

Inefficient markets might include emerging markets or even developed-world small caps, which are covered less than large caps by analysts.

Conversely, US large-caps should sit at the opposite end of the scale and be very hard to outperform. Yet more active-bashing data suggests things are not so straightforward.

In its mid-year scorecard of active management versus benchmarks, the benchmarks frequently win. In line with the efficient markets theory, S&P Dow Jones Indices (S&PDJI) found most active fund mangers (59.58%) failed to beat the large-cap S&P 500.

But S&PDJI also found that even more active managers underperformed the mid-cap US and small-cap US benchmarks – 68.88% and 64.27% respectively.

Performance figures were equally unfavourable for active funds when viewed over three-and five-year horizons.

In a forgiving mood, it might be argued that US equity markets, with an abundance of information surrounding them, are simply too efficient for many actives to beat, regardless of the market-cap size. Yet the figures are just as poor for international and global funds, and worse still for emerging market funds, where 74.53% of active funds were outperformed by benchmarks over five years.

A notable exception in the US numbers was for the one-year small-cap growth category. Forty-nine per cent of active managers failed to beat it.

“The data say there is no more likelihood of outperformance in what seem to be less efficient markets than in more efficient markets, like the US,” says Craig Lazzara, global head of index investment strategy at S&PDJI.

“What’s clearly true, certainly in the US, is that large-cap stocks are more researched than small caps, so you’d expect large caps would trade close to fair value most of the time and the likelihood of a mis-valuation is fairly small.

“Yet should less analyst coverage imply that small-caps are undervalued, then that’s an argument you are going to have to make. There may be a mis-valuation, but not necessarily an undervaluation. And if there’s not undervaluation, then that argument for using active management in the small-cap arena disappears.”

Further, says Lazzara, in an environment where it is harder to short small-cap stocks because of their availability, the chances of small-cap overvaluation may be higher.

While the active debate rages on after some perhaps 40 years, research has been carried out to see how investors allocate between the two options.

Ursula Marchioni, Emea director of investment strategies and insights at BlackRock, which owns the iShares ETF business, says: “Investors often tell us they make their decisions based on the performance dispersion within a market. Dispersion in the risk-return profile in US large-caps is very limited, meaning an investor would have to get it extremely right to pick a manager who can outperform.”

Emerging markets are where people feel opportunities exist for the active manager to outperform, Marchioni says. 

“However, if we look at the flows and assets under management in emerging market ETPs and ETFs, we see that several investors are also moving towards passive emerging market allocations.”

She says this might be because there is a significant index and product offering now for emerging market exposures.

“The ETP market is very granular across the beta continuum. Investors are becoming more familiar with emerging markets and are looking at them in a more laser-focused manner. Some are capable of having views such as on China versus Brazil, for example. They want to un-bucket emerging markets using single-country funds.”

The existence of very well established indices may be a reason for even less experienced emerging market investors to be confident enough to allocate passively.

Fixed income is more polarised between active and passive.

“The high yield and emerging markets sectors are where some investors are still more likely to select an active manager because they want the manager to look after the default risk,” says Marchioni.

Though even here, the growth of the “beta continuum” in fixed income is growing and investors can be just as laser focused, too.

“Investors are able to move away from broad benchmarks and focus on subcategories… and place duration plays within them. Not only can ETFs capture overall duration, but they can also access the short and long ends of the curve.”

It should, of course be noted, that many active managers – if not most – have beaten their indices and that for sophisticated investors with the research means, there is a variety to choose from.

Marchioni says the decision to go active or passive for a given exposure might also be time dependent, based on the economic cycle.

The active versus passive debate, meanwhile, is likely to run for a lot more time yet.

©2013 funds europe



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