Arguments about the merits of active versus passive investing are increasingly outmoded, but the debate has seemingly propelled proponents from both disciplines to innovate.
While fund groups base their marketing efforts on adding value through boasts of high active share figures, unconstrained and high-conviction strategies, providers of exchange-traded funds have upped the ante with pioneering new approaches to ‘smart’ beta, blurring the active/passive boundaries.
Providers of traditional index funds, meanwhile, have responded by lowering fees to increasingly attractive levels, so long as you believe markets are going to rise.
Unconstrained or not, benchmark indices should be of concern to all professional investors, and there is plenty to ponder – not least in the UK where the proposed merger of Shell and BG is set to account for about 10% of the FTSE 100, as well as a fair chunk of its yield.
“It is going to be an interesting development for active managers, because there is a 10% limit on what you can hold in an open-ended collective,” says Tim Cockerill, investment director at Rowan Dartington.
“If you have an index position of around that size, you cannot overweight it, because then you are breaching the diversification rules. At best, you can hold market weighting but, of course, market movement could conceivably push it up to 11%, in which case you will continually be trimming it back. If your benchmark is the FTSE 100 or All-Share, then your position against that stock can determine your relative performance to a large extent.”
Resource bias
The Shell-BG deal will do little to calm analysts’ perennial worry about the bias of the index to resource stocks. Still, despite the scale of Shell and BP, current demand/supply metrics mean oil and gas firms are far from bubble territory.
While the FTSE may well have breached record levels this year, it is easy to forget that when it last previously traded at these kinds of heights, it was a very different beast, with about half of the companies that contributed to highs in December 1999 having since left the index.
So what should investors take into account today when investing against the major equity indices?
“With index investing, you know what you are going to get but you don’t know the result,” says James Calder, research director at City Asset Management.
“You know you are going to get the index but you have no idea what the index return is going to be. You want access to markets and you are basically looking for cheap beta because there is no alpha there – there is no added value.”
An advocate of selecting managers who adopt an unconstrained approach, Calder believes one of the main reasons why active fund managers on aggregate underperform their benchmark is because of restrictions on their mandates.
Active myths
“You have quite a few funds in any peer group that are badged as active, but investors always need to be aware that they are often basically ‘passive-active’, with constraints on the manager that are quite severe,” he says.
“If, for example, he or she is operating in the UK space, it is not uncommon to have restrictions where you can over or underweight a sector by 5%, and at stock level by 2-3%.
“Say the index constituency is 7% and, if you really like it, you can go up to 9%, or if you don’t like it you can go to 5%. In the latter, you still have to hold something you don’t like – the index is the be all and end all.”
Certainly, active share – how an equity portfolio’s holdings differ from the benchmark index constituents – has come to prominence as a battleground for fund managers this year.
For example, Columbia Threadneedle, Baillie Gifford and Woodford Investment Management have all made moves to disclose active share in their funds, while, in February, Neptune CEO Robin Geffen called on the FCA to make disclosure of active share mandatory for fund groups.
“This is fundamentally about transparency, on which the FCA has rightly put an emphasis in recent years,” he says.
“I believe there remain in Britain financial institutions that have promoted active management products in their shop windows, while stashing billions of pounds worth of assets invested in closet-trackers under the counter.
This damages active management’s reputation and leads us back into the hackneyed active versus passive debate, when the real debate is between passive, closet-passive and truly active.”
Search for transparency
That these groups have taken it upon themselves to offer up more transparency can only be a good thing, although, taken in isolation, active share in itself does not a good fund manager make.
In a research paper issued last year, Active share: a misunderstood measure in manager selection, Fidelity Investments argued that while active share may help investors compare active managers, it is not a consistent measure across different market-cap size mandates and benchmarks.
The results suggested small-cap funds disproportionately had very high active share, in the 95-100% range, while large-cap funds showed a more normal distribution, with a median and mean both near 75%.
“Our analysis suggests that for large-cap managers in the 15-year period observed, the relationship between higher levels of active share and excess return appears to have been primarily driven by smaller-cap portfolio exposures,” it reads.
“Given these observations, investors should be wary of trying to make precise distinctions about manager skill or return potential using active share alone.”
Why has all this become such a big talking point now?
Post-RDR, cost has become much more of a concern for wealth managers in making sure they get the very best value for their clients. It is indeed a primary reason why the active versus passive debate has been relegated to history – many intermediaries say they are happy to use trackers and a satellite of more expensive alpha- generating managers within the same portfolio.
It seems the enemy of active and passive investors are the ‘benchmark huggers’ that charge a high fee in exchange for sub-standard results.
Biased it may be, but fresh research from Vanguard found from examining the performance of a range of actively managed and index mutual funds available to UK investors, when funds are split into lower and higher-cost quartiles, the low-cost funds outperformed those with higher costs in 10 out of 11 investment categories over the 10-year period to year-end 2014.
In aggregate, low-cost funds outperformed high-cost funds by an average of 1% pa over the period.
While tracker funds continue to compete on issues of simplicity and cost, however, the world of ETFs is becoming ever more complex through the growth in the world of smart beta strategies, which is arguably a middle-ground between active and passive investing.
Equally weighted, thematic biased, minimum variance and dividend-focused smart beta strategies have all gained traction in recent years.
In April, wealth manager Seven Investment Management joined the fray by unitising its in-house smart beta approach with the launch of a range of value-focused funds that are investing in low-priced equities across the UK, Europe, US and emerging markets.
The aim is to offset periods of underperformance in value investing – stocks are selected on the basis of neutralising sector, small-cap and momentum biases.
At the same time, Lombard Odier Investment Management, which is known primarily as an active manager, is working with ETF Securities on the launch of fundamentally weighted smart beta government and corporate bond ETFs.
Meanwhile, S&P Dow Jones Indices is hoping to profit from renewed interest in ESG (environmental, social and governance) investing with its DJSI Ethical Europe Low Volatility Europe. Its constituents are weighted relative to their corresponding volatility, with the least volatile stocks receiving the highest weights.
Comparison criteria
Rayner Spencer Mills Research rates passive alongside active funds by considering four factors: business – the preferences is for firms that are focused solely on passive management; people – resourcing in terms of size, focus and turnover; process – managers can differ in the degree to which they track the index, ranging from fully replicated to more optimised approached; and finally fund criteria – past performance and tracking error versus the benchmark.
Chris Riley, investment research manager at RSMR, stresses that while smart beta funds have the ability to add value for investors, he prefers a more sophisticated active quant approach offered by the likes of the Schroder QEP Global Core and JPM UK Active Index Plus funds.
“I am concerned that some smart beta products are constructed in a very simplistic manner and are generally structured to only give exposure to a single factor,” he says.
“I would prefer a more multi-faceted approach, where you can get all of the smart beta factors – value, momentum, quality and yield – in a single product.”
April marked 15 years since the listing of the first ETF on the London Stock Exchange, with the market having grown to a staggering £185.8bn in turnover last year across some 791 listed funds.
As described earlier, the wealth manager community has embraced ETFs alongside traditional active funds.
Still, Calder says he generally only uses ETFs to access specialist asset classes, such as physical gold funds to get as pure as possible exposure to the metal.
“However, saying that, there is one asset class where I think there is a very strong argument for using passives and that is US equities,” he says.
“We are very much of the view that active managers, if you can find the right ones, do outperform on a consistent basis, but the US is one of those areas where it is very difficult to find those guys.
“We have previously used structured products to get US exposure, but we now use ETFs for some clients where there is a strong structural US mandate.”
All in all, wealth managers have more choice than ever in how they invest across different asset classes, although for a large proportion of that community, active managers still win over – when they can add genuine alpha.
With equity markets at a high, and with more volatility likely, vanilla tracker funds could be in for a rough ride ahead. Still, if you are looking for innovation on a budget, smart beta products offer a real alternative.
