Active versus passive investing

active-passive-roadsignBy Steve Blizard

One of the longest-running financial debates focuses upon on whether it is better to invest in funds that are actively managed versus “passive” index funds.

This debate was recently given an additional boost when the world’s best known active manager, Warren Buffett, suggested in his latest annual Berkshire Hathaway letter that most investors would be better off investing passively and that he intended to place the vast majority of his huge estate into a very low cost Standard & Poor’s 500 stock-index fund.

Buffett is a long-time fan of Vanguard Group’s Jack Bogle, who champions low-cost index investing.

But this is the first time, Bogle said in an email exchange with Reuters, that Buffett was, to use that old cliché, “putting his money where his mouth is in his own estate.”

Sadly this debate is often reduced to an overly simplistic level where investors are forced to choose between an index or an active approach only, with no mixing of the two being possible or desirable.

Even Buffet seems to indicate that only smart investors such as him should invest actively, and that most “ordinary” investors should simply hold index funds.

More worryingly, the discussion is often divorced from practical portfolio implications, resulting in major misunderstandings and unnecessary inflexibility.

Active fund managers maintain they add value to investors from the stocks they specifically select, compared to a broad stock market index, typically market capitalisation weighted.

This added value is referred to as “alpha”.

Supporters of index investing often include those who believe it is too difficult to consistently exploit inefficiencies in stock markets.

Believers in an index investment approach maintain that the most powerful “proof” is that US mutual funds [or Australian managed funds], on average, have underperformed the stock market index.

However, underperformance in a majority, but not all categories of the “average” managed fund, proves little about market efficiency or the ability of certain managers to outperform consistently.

At Roxburgh, while our research of active fund managers reveals a core group of managers who can outperform the relevant index, there are many other managers who underperform.

This poor performance is often due to large components of their portfolios shadowing the index.

A study of equity fund managers has also identified other reasons for this underperformance.

In the March 2009 version of their paper titled, “Best Ideas”, Randy Cohen, Christopher Polk, and Bernhard Silli, attempted to identify which holdings in equity mutual fund portfolios represented the high-conviction, “Best Ideas”, of various fund managers and then measured the performance of those stocks after the conviction becomes apparent.

They found that US mutual fund managers with the highest conviction ideas did indeed outperform.

However this “alpha” was offset by also holding a larger range of stocks, many of which performed more poorly.

In their view, they found that investors would benefit if mutual fund managers held more concentrated portfolios.

A $10,000 investment in Warren Buffet’s actively managed Berkshire Hathaway stock in 1965 would have grown to be worth nearly $30 million by 2005.

That’s about sixty times as much as you would have made if you’d invested $10,000 in the Standard & Poor’s 500 Index and held it for those same 40-years.

Interestingly, recent analysis of Warren Buffet’s performance shows that while he has delivered significant outperformance “alpha” since 1965, even he has not added any value over four of the last five years, despite enjoying some unique post-GFC deals.

This suggests that index funds can underperform actively managed funds, depending on the particular time frame in question.

At Roxburgh, we research and talk to smart managers, so as to understand their strategy and how they achieved their returns.

There’s no rule that says you must invest entirely in active or index funds across portfolios, or that you can’t mix the two approaches and change the mix over time.

For example, in Australia, small-cap managers have consistently outperformed the index over longer term time frames due largely to the limited research coverage in that area.

There is clearly a place for both active and index funds in portfolios without ending up with an incoherent investment philosophy.

Indeed, our willingness at Roxburgh to recommend index funds at times ensures we are continually looking for active fund managers with the conviction that they can add extra value.

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