23 Jun 2011 | Opinion

Passive Aggression

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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.

Comments

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I’m afraid a lot of people do believe that the market cannot be beaten, because of its supposed efficiency. You are more sensible than that. I agree that active managers on average are average, but that is unsurprising. They also hold their share of overpriced large caps – on average – but as you regard the active management fee as a premium worth paying for a particular manager, not an average one, I don’t see why you think that matters. Perhaps you are right that my time would have been better spent writing about what to look out for in a manager that has a good chance of beating the market. This article was an attempt to persuade people that such a search is worthwhile.

Edward Hocknell

This article is really quite ingenuous. It's a very defensive article to be writing in a magazine whose readership must be made up almost entirely of people (like myself) who have invested in actively managed funds. The article just set up arguments to knock them down. No proponent of passive investment really claims that the market cannot be beaten. That's just a caricature. The efficient market hypothesis is quite separate from the active vs passive debate. The real point is that some people beat the market and others don’t and the two balance out. Often those who beat the market one year are the same people who failed to do so the previous year. The question is not whether investment managers can beat the market, it’s whether the individual investor can reliably identify those who are likely to beat the market next year or ideally consistently over the next few years. The extra cost that is paid for active investment is not a premium that is paid for better performance. It is a premium that is paid for the right to exercise your own judgement on whether a particular manager can produce above market performance or not. I’m happy to pay that premium in the case of Scottish Mortgage because I believe that its manager is capable of delivering above market performance on average over the next few years. The fact that it stands at a discount in the market suggests that the market doesn’t agree with me, but that’s the risk I take. The average investor in an actively managed fund will get market performance less investment costs. The average investor in a passively managed fund will get market performance less rather lower costs. So the average passive investor does better than the average active investor, and this is true whether the market is rising or falling. It’s just a matter of arithmetic. Some active investors will do spectacularly better than passive investors, but they must be balanced by active investors who do worse. Similarly the claim that passive investors have to hold the ‘current market emperors’ is true but irrelevant. Active investors as a group have to hold these stocks too. Passive investors hold no higher a proportion of these stocks than they do of other stocks, so active investors hold no lower a proportion. Individual active investors have a choice, but as a group they must hold them, so if they do badly then some active investors will do better in relative terms, but just as many will do badly. It’s pointless for the proponents of active investment to make the sort of naïve claims in this article. Edward Hocknell should instead be aiming to convince investors that BG managers are likely to be in the 50% or so of active managers who will do better than passive managers, rather than in the 50% who will do worse.

Alastair Jollans