Passive v Active: A Chief Investment Officers View: Part Three

If you’ve not read my previous articles you will find them here: Part One  Part Two

In this final article, I take a look at the US in more detail and the summarise:

As we have done with the UK, we are now going to conduct the same research for the US.  Our core US Equity holding is Neptune US Opportunities and the benchmark index is the S&P 500.

 

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The question of passive versus active in US large cap came about following US academic studies that noted long term underperformance of active managers.  In a widely cited study by Lakonishok, Shleifer, and Vishny (1992) questioning the future of the US Defined Benefit (DB) industry.  Their study of 769 DB plans underperformed the S&P 500 by 260 basis points per year during 1983-1989*.

The rolling monthly returns gives the probability edge to the passive approach, with the S&P 500 outperforming in 31 of the 60 periods.

 

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Increasing the rolling periods to 1 years, still a short term measure, the passive style is in favour with outperformance occurs in 40 of the rolling periods.

 

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The first look at longer term performance swings the probability back to active management, with the actively managed fund outperforming in 42 of the 60 rolling periods.

 

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Taking the longer term view of 10 years, the number of rolling periods is reduced to 20, as the fund launched in December 2002.  The trend of probability continues with the actively managed fund outperforming the index 100% of the time.

For information purposes, the cumulative performance since the fund launched looks like this:

 

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So in this example of a core US Equity fund against the S&P 500 index, the probability of the passive or active outperforming over particular rolling periods is shown in the table below:

 

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So while the debate over passive or active style is too close to call over the short term, it becomes clearer on the basis of probability over the longer term.

Conclusion

If there is any, it is that over the short term, the debate for passive is stronger, while over the long term the weight is more towards active management.

Part of being a fund manager is having an investment belief and the philosophical argument of passive versus active relates to this core belief.  We run the Equip portfolios with a bias towards long term investing and I believe that mirrors what active management is looking to do.  Passive investing, to me, captures the sentiment value, while active investing captures the fundamentals and I believe we are better placed to capture long term fundamentals, rather than short term sentiment.

That is why I think we need to clarify our investment propositions.  Differentiation is key to a robust investment process, whether that is at fund level, portfolio level or process level.  We have two very good investment portfolios: Equip and PFP (Price Focused Portfolios).  I propose we maintain the approach we have always had with Equip, over the past 10 years and that is a long term approach which lends itself to active management.

The Equip investment style is looking at longer term returns and adding value.  This cannot be done by inserting a tracker or passive fund over short periods.  If I do not have conviction that an active approach for a particular asset class can add value over the long term, then it is right that we would should be looking at adding cheap Beta to the Equip portfolios?  So focus needs to be on the long term, not the short term and this it born out by our long term performance figures for Equip, where we have beaten the composite benchmarks, on average on a quarterly basis, more than 75% of the time.

With PFP we could look to make this a wholly passive offering, as we currently run this as a quasi-passive in the guise of managing costs.  Price Focused then becomes Passive Focused.  The client can then choose between the cost of active management and the risk of passive management.

We have then matched our long term investment philosophy with the correct style, while offering an alternative style to those clients have had a shorter term horizon or wish to remove the additional cost of active management.

Summary

  • The argument between passive and active investment is complicated.
  • The foundation of the research should be focused on investment term.
  • Conviction in the Equip portfolios is towards longer term investing.
  • Longer term investing is more conducive to active management.
  • It therefore makes sense that the Equip portfolios have a bias towards active management.
  • Shorter term investing is more akin to passive investing.
  • The importance of differentiating our investment propositions is critical.
  • Develop the PFP to have a bias towards passive investment, though explicit driver is cost.
  • The biggest factor in passive investing is cost, which correlates to PFP.
  • The biggest factor in active investing is risk, which correlates to Equip.

Executive Summary:

To write this paper involved challenging my long held philosophies and investment beliefs.  I thought long and hard over this topic and eventually came to the conclusion that Equip, which is firmly focused on long term investing, is more suited to active management than passive management.

I also belief that if a client is satisfied with market returns, at a lower cost, it may be that passive investing will suit their requirements and for that we also have a solution.

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