23 Jun 2011
Actively managed investments are not necessarily
more expensive or risky, argues Edward Hocknell.
Sherlock Holmes once said rather dismissively of his eternal foe, Professor Moriarty, that he had written a paper on the binomial theorem which enjoyed a ‘European vogue’. Passive investment is a rather supine approach, which allocates money according to a stock’s weighting in an index. It is the eternal foe of active investors like us, and it has enjoyed a vogue, which is not merely European – it has swept the world.
There are three arguments used in favour of passive investment: it is relatively cheap, it is lower risk than active management and it produces better performance. The first argument is sometimes true; the other two are either wrong or at best, misleading. Yes, passive investment is often, but not always, cheaper. There are some shocking examples of passive funds, which charge more than the active alternative, but most do not. This is not surprising, as the passive approach involves no analysis or judgement; if BP is 5 per cent of the index, that is what you get.
Happily, active management in investment trusts is also quite cheap. The total expense ratio for Scottish Mortgage Investment Trust PLC or The Monks Investment Trust PLC is about 0.6 per cent. A reasonable tracker costs about 0.4 per cent. So the passive approach is slightly cheaper; but in practice a good active trust will have outperformed its benchmark by much more than its extra cost in the long run, therefore the cost argument is not a strong one for the trackers.
The arguments about risk and return are more interesting. They derive originally from modern portfolio theory and the idea that markets price assets with an efficiency which no human agency can match. The ‘passive is low risk’ argument depends upon the assumption that the market itself is not risky, and that investment risk only arises from divergences from the benchmark; that risk is actually volatility compared to the market.
It is rather like saying that, during an ocean voyage, it is safest to stay on board even if the ship is sinking. In real life, risk is the likelihood of losing money. It has nothing to do with volatility.
It just takes one more push to send our foe, the champion of passive investing, plunging over the Reichenbach Falls (the location where Sherlock Holmes apparently dies in his final struggle with Professor Moriarty). The modern day Moriarty maintains that passive is best because, being efficient, the market cannot be beaten. This is clearly not right. The wild gyrations of the dotcom bubble, the persistent overvaluation of banks before the financial crisis and countless other examples have convinced most people that the market is not rational. The market is hard to predict in the short-term, but that is precisely because it is irrational and is driven by irrational beings, not because it is efficient. It can be beaten in the long run by investors who take a sensible approach.
Admittedly markets are sometimes quite hard to beat – usually when almost all share prices are going up or down together. I have a strong suspicion that the future will not be like that. We are living through a period of profound change. Many current market emperors have few clothes. Their valuations are a relic of the past, but those valuations accord them a heavy weighting in market indices and hence in passive portfolios. So passive investment is essentially backward looking - and this is a particularly dangerous time to drive by looking in the rear view mirror.
Please remember that the value of a stock market investment and any income from it can fall as well as rise and investors may not get back the amount invested. Investments with exposure to overseas securities can be affected by changing stock market conditions and currency exchange rates.
Author: Edward Hocknell
Edward graduated BA in Classics & Philosophy from Oxford University. He joined Baillie Gifford in 1984 and became a Partner in 1998. Edward is a Director in the Institutional Clients Department with responsibility for North American clients. He is a member of the Investment Policy Committee.