Since the Global Financial Crisis (GFC) investors have flocked to passive investments; as illustrated in figure one, exchange traded products (ETPs) have been the recipient of much of this funds flow.

This trend has been attributed to several factors; a reaction to poor relative and absolute returns from active funds during the GFC, cost sensitivity, and fear of capital loss. Investor behaviour is not always rational and is often driven by fear and emotion.

The passive approach

Passive management provides investors with an exposure to an underlying index or asset class; it may be a broad exposure, such as the ASX200, or something a little more niche, such as exposure to a sector or investment theme. Investors receive market returns, known as beta, less fees and costs.

Market beta is typically provided at a lower cost than returns from active management, where investors pay for the skills of a fund manager who aims to deliver alpha, or performance above a specific benchmark.

The proponents of passive investment claim the following benefits of this investment approach:

• Costs – management fees and costs are generally significantly lower than for actively managed investments
• Diversification – and index or exchange traded fund (ETF) can provide instant exposure to a diversified portfolio of securities within a given asset class
• Transparency – particularly in the case of ETFs, issuers publish holdings each day, providing a high level of transparency
• ETFs have the added bonus of being able to be easily traded on the ASX, which provides flexibility and liquidity.

While passive strategies may provide broad market exposure, history tells us that markets can – and will – have downturns. While a passive index strategy will gain all that its benchmark gains, it will also lose everything its benchmark loses, less fees and costs. Therefore, those investors who view passive investment as a ‘set-and-forget’ strategy may be adversely affected in market downturns.

Consider figure two, which shows the position of companies in the ASX200 on the day of writing; a greater number are experiencing falling share prices than rising. An investor with passive ASX200 exposure experiences this upside – along with the downside.

The active counterpart

An active manager attempts to beat the index (or generate ‘alpha’) by selectively buying and selling securities in a custom portfolio.

In an ideal world, the active management of a portfolio should enable the manager to capture value from markets and individual securities, and avoid damaging situations. Corporate Australia has experienced its share of failed companies and while passive investors would be exposed to a Timbercorp, an HIH, or the asbestos crisis that plagued James Hardie Industries, the research undertaken by active managers should enable them to avoid such hazards.

Proponents of active investing offer the following advantages:

• Active managers can take advantage of short-term mispricing opportunities to generate positive relative and absolute returns
• In falling markets, the active manager can reallocate assets to de-risk a portfolio
• Some sectors that are less researched, such as smaller companies or emerging markets, offer greater opportunities for mispricing; therefore, active management is a more appropriate strategy.

Whether or not active managers add value after fees, over the full economic cycle, has been a widely-contested topic in investment circles for many decades. The debate is founded upon the efficient market hypothesis; an investment theory that questions whether in fact financial markets are proficient in allocating economic resources and information. As the name implies, the function of the capital market is to efficiently allocate capital: the share price of a good company should rise so that it can raise money and expand, while a less well-run company should go out of business so that its assets can be reallocated to more productive purposes. However, the reality is that markets fail to achieve this in a timely manner, creating market inefficiencies and opportunities for active managers to exploit.

The concept of ‘fair value’

The notion of ‘fair value’ is important in this debate. Fair value is the rational, unbiased underlying value of an asset. By understanding the fair value of a security, it is possible to generate profit by investing or withdrawing capital respectively to the extent that the price level deviates from that fair value at any point in time. This requires an active investment philosophy that is both information-based and forward looking in an effort to understand the dynamics of the real economy and the security in question. Put another way, it requires fundamental investors to actively research and seek price dislocations to arbitrage, to keep capital flowing efficiently.

Passive investing employs the opposite approach – asset allocation simply seeks to apportion more capital to those companies that appear to be outperforming based on their recent past; it is determined by backward looking momentum. This makes index investing akin to driving up a windy cliff road while only looking in the rear-view mirror! What’s more, under this dynamic there is no self-correcting price mechanism, so capital inflows are greatest when past performance has been the highest. Stocks that have rallied become larger constituents of the index or benchmark, which leads to sector biases such as the Commodities Boom of the 2000s or Dot-Com bubble of the late-90s.

Index investors are therefore directing a higher proportion of their investable assets into these higher priced (and therefore arguably riskier) stocks and sectors. This is contrary to the popular belief that index investing is ‘low risk’. Perhaps we are seeing another bubble today with the rise of infrastructure, healthcare and property trusts – some of these companies trade at price-to-earnings (P/E) multiples of 75 times…is it prudent to allocate $75 of capital for $1 of earnings?

Proof of alpha

There’s often a lot of contention surrounding the proof of alpha. In theory, it’s a zero sum game; for one manager to outperform, one needs to underperform – however evidence within Australian Equities paints a different story, as shown in Figure three.

As illustrated, active management in Australia works, with the average active manager surveyed outperforming the S&P/ASX 300 Index, and more impressively, even the 75^th percentile manager surveyed outperforming, before fees. As is evident, the Perpetual Concentrated Equity Fund^*, Perpetual SHARE-PLUS Long-Short Fund^† and Perpetual Ethical SRI Fund^‡ all substantially outperformed both the index and the average active manager.

The fact that active management is rewarded in Australia can perhaps be explained by inexperienced domestic and offshore players who have different investment objectives and different benchmarks. Intuitively, most offshore managers would be measured relative to the MSCI Index – not the S&P/ASX 300 Index – and we suspect that having different objectives and benchmarks alters the zero sum argument.

Perpetual Investments long-term alpha generation

Achieving market returns (less fees) by investing with a passive manager is an entirely reasonable strategy for many investors. Perpetual Investments, however, takes a different approach – seeking to achieve more than just market returns for its investors, and has a long track record of generating alpha, as demonstrated in figure four.

Warren Buffett, perhaps the greatest value investor of all time, once stated “diversification is protection against ignorance. It makes little sense if you know what you are doing”. This mentality resonates with Perpetual’s investment managers who continually demonstrate their conviction by selectively investing in companies that they fundamentally understand, and consider themselves long-term owners of businesses rather than simply shareholders.

As a bottom-up, fundamental investment manager, Perpetual continues to seek out alpha opportunities by investing in high quality but undervalued companies. It is our disciplined approach, together with our conservative attitude towards managing money, which has helped us consistently outperform the broader market over the long run.

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*Registered name, also known as Perpetual Wholesale Concentrated Equity Fund
^† Registered name, also known as Perpetual Wholesale SHARE-PLUS Long-Short Fund
^‡ Registered name, also known as Perpetual Wholesale Ethical SRI Fund

This document has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426 for financial advisers only. It is general information only and is not intended to provide you with financial advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The information is believed to be accurate at the time of compilation and is provided in good faith. This document may contain information contributed by third parties. PIML does not warrant the accuracy or completeness of any information contributed by a third party. Any views expressed in this document are opinions of the author at the time of writing and do not constitute a recommendation to act. The product disclosure statement (PDS) for the above funds, issued by PIML, should be considered before deciding whether to acquire or hold units in the fund. The PDS can be obtained by calling 1800 022 033 or visiting our website www.perpetual.com.au. No company in the Perpetual Group (Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of any fund or the return of an investor’s capital. Past performance is not indicative of future.

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