Overview
The debate over active versus passive management is not a new one. In the 1960s the world saw Eugene Fama develop the theory of the efficient market hypothesis and its role in asset allocation. The argument over whether the market can be beaten has continued to rage worldwide. If capital markets were at equilibrium, the case for active management would be non-existent.
Active management is defined as taking active positions in the market, based on observations of the market, macroeconomic factors and company specific news, with a view of outperforming the market benchmark. Active managers believe the market is not efficient and that securities can be mispriced and that superior returns can be generated by exploiting these inefficiencies.
Passive management, also known as indexing, usually involves investing in an index (such as the S&P/ASX 300) as a proxy, or taking individual stock positions with the same weightings as the market benchmark, in the belief that the market cannot be beaten. Passive management, compared to active management, requires fewer portfolio decisions. These fewer portfolio decisions can help to minimise transaction costs and the impact of capital gains tax. Generally speaking, index managers charge lower fees than active managers.
While historically, investors gained access to passive management via unlisted managed funds, the market has evolved so that now investors can gain access to indexing or passive management through exchange traded funds (ETFs). The ETF market in Australia is still in its early stage of growth. In the US and Europe, the ETF market has grown substantially over the years. In 2008 alone, over $US 200 billion was invested into ETFs.
In the bull market of 2004-2007, investors questioned the value of active managers, as many funds appeared to underperform the market (and in turn, passive managers). Active management will not always consistently add value and there are certainly market environments and sector conditions that are more conducive to outperformance. Some asset classes are better placed than others to provide sufficient opportunities for active managers to exploit.
In general, Lonsec believes that quality active management in equities and more generally, those assets managed on a global basis, is superior to passive management, if the aim is to maximise returns over time.
However, in some sectors, such as domestic listed property and domestic fixed interest, Lonsec believes the case for active management is less compelling. In these instances a passive approach may be appropriate.
This paper examines the factors impacting each asset class in relation to the active versus passive debate and the rationale behind Lonsec’s current views.
Equities
Lonsec believes that active management in equities is, in general, superior to passive management, if the aim is to maximise returns over time.
Historical evidence
Historically, active managers in Lonsec’s universe have added value in both Australian and global equities. The table below summarises the value added by the average and top quartile funds within Lonsec’s full universe of equity managers, over the past three and five years.
In most cases, the average active manager has been able to add value by way of excess returns above the market (and hence passive funds). It is important to recognise that all these results are post fees, so active managers have more than compensated for the active fee that they charge, by way of positive excess returns. However, investors should remember that an ‘average’ result hides a lot of variance within the fund universe – there will always be some funds that do even better and some that perform poorly.
When the universe is narrowed to examine the top quartile managers, the results are (not surprisingly) even more convincing. Results within higher growth sectors, such as Australian equity small caps, are particularly compelling, with the average manager consistently outperforming the market by 4% over the past three and seven years.
The results above also hide some variations in relative performance throughout a market cycle. Typically Lonsec has observed that active Australian equity managers tend to deliver better relative returns in sideways and falling markets and may struggle to keep pace with the market when it is rising strongly.
The bar chart below demonstrates this observation, with a majority (69%) of managers outperforming during the bear market, while most lagged during the rally.
In bull markets, such at that during 2004-2007, quality stocks may not rise as dramatically as highly leveraged or speculative stocks, or at best keep pace with the market. Often in bull markets investors are less discerning and general confidence in the market outweighs stock specific concerns. In markets where quality (i.e. companies that exhibit strong fundamentals such as balance sheet strength) is not rewarded,, active managers typically find it more difficult to outperform the market and it can be harder for investors to distinguish between manager skill and luck.
Another example of this was seen during the late 1990s ‘tech bubble’, where many active managers were punished for being underweight in strongly performing new technology stocks, based on the view that their fundamentals were unsound. Although these managers underperformed as the market rose, as the bubble burst they began to outperform and more than recouped their previous losses.
Qualitative factors to consider
Some sectors, including small caps and emerging markets, are often more inefficient than the broader market, Lonsec believes that active management is more appropriate to maximise returns in these sectors. These markets are often under-researched by the investment community and can provide an opportunity for well placed active managers to capitalise on an information advantage that they may have.
In contrast, more developed and over-researched markets, such as the US large cap equity market, generally provide a more difficult environment for managers to deliver consistent outperformance. This is an important distinction to make, as much of the industry literature relating to the ‘Active versus Passive’ debate, makes reference to the poor returns of active managers in the US. Investors should remember that there are many other equity markets which provide opportunities for active managers, outside the US.
Passive managers are, by definition, style neutral. In contrast, active managers may choose to have a style or thematic tilt to their portfolio, depending on their stated process or view of the market at a certain point in time. The ability for active managers to bias their portfolios to certain factors can provide scope to increase returns in different economic conditions. For example, currently investors are increasingly concerned about the risks of inflation, as well as the threat of a sustained period of low economic growth, from the developed economies in particular. While they may not always get it right, active managers have the flexibility to position their portfolios to select securities, sectors and regions (in the case of global equities) that are in a better relative position to benefit from such themes.
Another important consideration is that passive global equity investing typically provides investors with market exposure in proportion with the MSCI World Index (the most standard benchmark referenced by Australian-domiciled global equity investors). This benchmark is constructed on a cap-weighted basis and is consequently dominated by the US – accounting for 55%. Furthermore, the benchmark does not include any exposure to emerging markets. In contrast, active managers can provide more diversified exposure to regional markets, including often material exposure to the higher growth emerging markets. Active managers have the ability to vary the exposure to each region, as they identify areas of opportunity and risk.
The following table summarises the regional positioning of a sample of active global equity funds, compared to the market MSCI benchmark.
Active managers also encompass a wide range of risk/return profiles, so asset allocation can be tailored to suit specific investor needs. Some active managers have a defensive approach and may have a bias to income, while others may be more growth oriented and more leveraged to cyclical upswings in an economy and market.
Property
The case for active management in Australian listed property (A-REITs) is not as compelling as some other asset classes. However, despite mixed performance results, Lonsec believes that, looking forward, there is greater scope for active global listed property managers to add value.
Historical evidence
The historical evidence in relation to listed property has been mixed.
With the exception of the last year, Australian and global property securities funds have failed to deliver positive performance, relative to their respective market benchmarks.
Qualitative considerations
The listed property sector in Australia is highly concentrated, with one stock (Westfield) comprising 39% of the S&P/ASX 300 A-REIT Index, as at March 2010 and the top five REITs in the sector making up approximately 75% of the index. There are only 23 stocks in the index in total, with many investors considering only half of those to be of investment grade.
What this means is that the opportunity set is very narrow and the skew of the sector to a dominant few stocks makes it more difficult for active managers to consistently add value, as they are required to take active positions across a ‘lumpier’ opportunity set. An active manager’s call on Westfield may have a disproportionate bearing on the contribution to active return (and risk) within the portfolio, given the dominance of that stock in the benchmark. If an investor is allocating to a true active A-REIT fund, then they need to be prepared to experience a return that is materially different to the market (either positive or negative).
Despite unconvincing performance results, looking forward the global property sector appears to provide a better opportunity for active managers to add value. The investible universe of securities is far more diverse, with a broad opportunity set of around 240 securities, across different geographic regions and sectors. On a global basis, Westfield comprises only 12% of the UBS Global Real Estate Investors Index and the top three REITs in the global sector make up only 15% of total market cap.
Country-specific factors can have a strong influence on the fortunes of regional property markets and this provides well resourced active global managers with scope to capitalise on the pricing inefficiencies that can arise. In this regard, Lonsec believes that it is possible to identify some active managers in this sector, with quality on-the-ground regional teams to enable them to cover the sector with sufficient depth of analysis.
While the qualitative case is supportive of an active approach to global property investing, quantitative results are, to date, less convincing. Lonsec will be monitoring the ability of active global property managers to achieve their stated objectives and to justify the active fee they charge.
Fixed Interest
The case for active management in traditional Australian fixed interest is not as compelling as some other asset classes. However, Lonsec does not extend this view to global products and believes that there is greater scope for global fixed interest managers to add value.
Historical evidence
Evidence has shown that in the past, Australian and global fixed interest managers have failed to add material value. The table below summarises the returns delivered by the average fund within Australian and global fixed interest respectively. A few points to note – recent performance has been strong, so there will be times when active managers do well. The global fixed interest sample size is small – only 4 managers – so these results need to be assessed with appropriate caution.
Qualitative considerations
There has historically been a relatively narrow opportunity set for Australian fixed interest. When coupled with the uninspiring performance evidence to date, it is difficult to make the case for active management within this sector at present. On this basis, within its model portfolios Lonsec has been recommending the use of a passive portfolio for domestic fixed interest. Lonsec is generally comfortable for this part of the portfolios to deliver a consistent, ‘no surprises’, benchmark-like return.
While the domestic universe has been relatively narrow, in line with the Government’s expansive fiscal policy, the amount of bonds on issue is expected to increase notably over the next few years. It is likely that the Australian fixed interest universe, as measured by the UBS Composite Bond Index, may increase from its current size of around $393 billion, to around $500 billion in three years time (Source: PIMCO). Such an expansion of the opportunity set may provide cause for Lonsec to revisit the ability of active managers to deliver sufficient returns (and do so consistently), to justify an active fee.
The results above also throw into question the merits of active management for global fixed interest. Certainly on historical performance results alone, active management is difficult to justify. However, consideration should be given to the opportunity set and particularly, how global debt markets have evolved over the past ten years. As the chart below shows, the global bond market has grown by a steady rate (an average of 14% per year), since 2001.
Growth of the global bond market
Source: PIMCO & Bank of International Settlements, As at 31/12/08
Global fixed interest is a much broader and deeper investment universe, with different shapes and levels of yield curves across regions, a greater range of sectors and many more corporate issuances available. This provides active managers with greater opportunities to add value via duration management, sector and regional rotation and credit selection. A broader opportunity set also allows managers to adequately diversify their portfolios. Lonsec believes that the ability for active managers to add value through security selection, sector rotation, regional selection and duration management will be relevant looking ahead, where issues such as sovereign risk become increasingly pertinent.
On this basis and taking a forward-looking approach, Lonsec believes that an active approach is warranted when investing in global fixed interest. Nonetheless, Lonsec will be monitoring the ability of active global fixed interest managers to achieve their stated objectives and to justify the active fee they charge.
A passive approach does not necessarily mean lower risk
There is sometimes a misconception that using an indexed or passive approach to investing is a lower risk strategy than utilising active managers. However, the devil is in the detail – it is important to define what is meant by ‘risk’.
If ‘risk’ is defined as deviations from the market (benchmark) then yes, a passive approach will ensure that the portfolio tracks more closely to the market and deviations (positive or negative) from the market return are expected to be low. This is captured by ‘tracking error’ – a measure of a fund’s return variability around the benchmark. However, it is important to remember that the market itself is certainly not immune from capital losses.
If ‘risk’ is defined as absolute deviations in returns, then passive funds are not necessarily less risky and in fact, there are many active funds that deliver returns with less absolute variability than passive funds. This is captured by ‘standard deviation’ – a measure of a fund’s absolute return variability.
Good examples are the following two global equity funds, both rated Highly Recommended by Lonsec. As the charts show, these funds have delivered returns with less return variability (standard deviation) than the market. The market is represented by the vertical axis (risk) and horizontal axis (return). So an outcome in the top, left quadrant shows a portfolio that has been less volatile than the market, with positive excess returns.
Snail trails of excess return and risk – rolling 3 years to 31 December 2009
Zurich Global Thematic Share Fund
Walter Scott Global Equity Fund
If ‘risk’ is defined as chance of capital loss, then passive funds are by no means less risky than active funds – although it will depend on the characteristics of the active fund. Many active funds will use defensive strategies, including increased exposure to cash, to protect the portfolio in volatile times and will often preserve more capital than passively managed portfolios.
Conclusion
The active versus passive issue is a long running debate and ultimately the decision to use either strategy depends on an investor’s objectives in terms of return seeking, risk management (although careful how we define ‘risk’), asset classes being used and ability to access both active and passively managed products.
The issue of cost is often cited as a reason for using passive funds, as passive funds are typically cheaper than active funds. However, the fee paid for investing in a product should only be an issue if the manager cannot recoup that fee through active returns.
When considering the case for active or passive strategies in each asset class, investors need to consider the opportunity set available to active managers. Historical results can provide some context around the ability of managers to consistently add value, but the future investment climate may be very different to the past.
Lonsec generally believes that active management is worth pursuing in equities and more generally, those assets managed on a global basis, if the aim is to maximise returns over time.
However, in some sectors, such as domestic listed property and domestic fixed interest, Lonsec believes the case for active management is less compelling. In these instances a passive approach may currently be appropriate.
Disclosure at the date of publication: Lonsec receives a fee from the fund Manager for rating the product(s) using comprehensive and objective criteria. Lonsec’s fee is not linked to the rating outcome. Costs incurred during the rating process of international funds, including travel and accommodation expenses are paid for by the fund Manager to enable on-site reviews. Lonsec does not hold the product(s) referred to in this document. Lonsec’s representatives and/or their associates may hold the product(s) referred to in this document, but detail of these holdings are not known to the Analyst(s).
Warnings: Past performance is not a reliable indicator of future performance. Any express or implied rating or advice presented in this document is limited to “General Advice” and based solely on consideration of the investment merits of the financial product(s) alone, without taking into account the investment objectives, financial situation and particular needs (‘financial circumstances’) of any particular person. Before making an investment decision based on the rating or advice, the reader must consider whether it is personally appropriate in light of his or her financial circumstances or should seek further advice on its appropriateness. If our General Advice relates to the acquisition or possible acquisition of particular financial product(s), the reader should obtain and consider the Product Disclosure Statement for each financial product before making any decision about whether to acquire a product.
Lonsec’s rating process relies upon the participation of the fund manager. Should the fund manager no longer be an active participant in the Lonsec rating process, Lonsec reserves the right to withdraw the document at any time and discontinue future coverage of the Fund(s).
Disclaimer: This document is for the exclusive use of the person to whom it is provided by Lonsec and must not be used or relied upon by any other person. No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented in this document, which is drawn from public information not verified by Lonsec. Conclusions, ratings and advice are reasonably held at the time of completion but subject to change without notice. Lonsec assumes no obligation to update this document following publication. Except for any liability which cannot be excluded, Lonsec, its directors, employees and agents disclaim all liability for any error or inaccuracy in, or omission from, this document or any loss or damage suffered by the reader or any other person as a consequence of relying upon it.
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