The debate around active vs passive investing, and which is better, continues to rumble on. But the reality is that the two investor types need each other.
What is active and passive investment?
Active investors aim to beat the market, passive investors simply track it
Active investing is a more hands-on approach. It involves researching single companies or funds and choosing a handful of those that are expected to outperform the broader ‘market’ as a whole.
Due to the research involved in choosing the ‘best’ stocks, monitoring them and then proactively trading around these positions, active fund managers charge fees typically in the region of 0.5-1.0% per year.
Passive investing is more hands-off. Rather than trying to choose which stocks are likely to outperform, you simply track the entire market and therefore earn a return in line with the underlying index (e.g. FTSE 100, S&P 500, etc.).
Passive funds are therefore typically more diversified (i.e. they’re invested in a wider range of companies), have lower portfolio turnover(it’s a buy-and-hold approach), and are significantly lower cost (as there’s less ‘skill’ and research involved) – most come in around 0.1-0.2% per year.
Which is better (in our view)?
We endorse a ‘rules-based’ investment approach – this sits ‘somewhere in the middle’ of active and passive (albeit much closer to passive in terms of diversification and cost)
The evidence against traditional active management is beyond any reasonable doubt – the vast majority of managers underperform once adjusting for costs.
According to SPIVA (data compiled by S&P Global), over the ten years to 30 June 2023:
· In the US, 86% of active funds underperformed the S&P 500 (main US stockmarket index),
· In Europe, 93% of active funds underperformed the S&P Europe 350, and
· In Japan, 84% of active funds underperformed the TOPIX 150.
Collectively, these three regions make up c. 81% of global market cap (i.e. the total value of publicly-listed companies worldwide). You can check the data out for yourself – click here.
As a result, we simply cannot endorse active management in the traditional sense.
That being said, we also see risks in the conventional passive approach.
"Momentum investing in disguise?"
This is well-summarised by Meryn Somerset Webb in a previous FT article, where she argued that passive investing is essentially momentum investing in disguise: “buy an index that is constructed in such a way that the greater the company’s market capitalisation, the more of an index it makes up… the truth is that passive investing is simply momentum investing. Buy in and you get to hold lots of stuff that has done well recently (and the more overpriced they are, the more you hold) and not much of the stuff that hasn’t”.
The ‘elephant in the room’ is that through a traditional index-tracking approach, a large proportion of your portfolio will be invested in US tech (at the time of writing, 7 of the largest 10 companies in the world sit within this sub-sector). These have performed tremendously well over the last ten years, surpassing all expectations in terms of the size and duration of their outperformance. And some would say this high tech weighting is no bad thing, particularly as we’ve only just begun to scratch the surface of Generative AI.
However, history tells us that the largest companies very rarely retain their positions from one decade to the next. As an example, ofthe ten biggest companies by market cap in 2013, only Apple, Microsoft and Berkshire Hathaway remain.
We therefore see risk in adopting a fully passive approach, certainly in the traditional sense, i.e. ‘simple’ index-tracking.
Our investment approach
We favour a ‘rules-based’ investment approach, one that largely tracks the market (a la passive investing) but with a modest skew or tilt towards certain sub-classes, aka. ‘factors’ (a la active investing).
This is based on empirical evidence that, over the long-term:
· Small companies outperform large,
· Value stocks outperform growth,
· High profitability companies outperform low profitability.
This approach shares more characteristics with passive investing vs active – high diversification, low portfolio turnover and low cost. However, it is designed to address some of the shortcomings of traditional passive investing (being over-exposed to those companies that have done well in the past, i.e. momentum investing).
Disclaimer: Please note that when investing, the value of investments, and any income from them, can go down as well as up, and you may get back less than you invested, particularly where investing for a short timeframe (we normally recommend a horizon of at least 5years). Neither simulated or actual past performance are a reliable indicator of future performance.
Passive needs active & active needs passive
The balance of power could shift back to active at some point in the future
One of the reasons why passive investing has been so successful (in relative terms) is that markets are pretty efficient. That is, they do a good job of fairly pricing all available information such that it’s really difficult to outperform.
Or put another way, there are still so many active managers competing for outperformance, that this is hard to come by.
But that might change at some point.
In terms of new inflows, passive investing is enjoying its time in the sun and as the overall proportion of money that is invested passively increases, this may start to create inefficiencies (as passive investors aren’t analysing individual companies which therefore limits so-called ‘price discovery’). At that point, active managers may be able to capitalise on said inefficiencies and exploit mis-pricing opportunities.
I don’t think we’re near that point just yet, but it’s important to reassess this on a regular basis.
