Every passive investor should believe in active management

Matt Gibson

Partner

LCP clarity:

An index-tracking approach is appropriate in some markets, but it should not be the default approach in all asset classes.

LCP insight:

Consider whether your passively managed portfolio is giving you exposure to the sectors and regions you want.

In this article, I look at investing passively or index tracking. A huge theme of the last three decades is the explosion of assets managed in this way, but few things divide opinion more in the industry than a good debate about active vs passive. That debate is more nuanced than commonly represented though with different considerations relevant in different asset classes.

What often goes underappreciated are some of the fundamental tenets of passive management – what do you have to believe to be true for passive management to “work”? Has it gone too far? What happens when all the assets in the world are managed passively? In this piece I try to answer these tough questions in order to give a framework for thinking about the choice between active and passive that all investors are faced with.

Passive investment

Many people who invest using an index-tracking approach believe that paying active investment management fees is poor value for money and a passive approach will provide better returns after fees.

There is an inherent irony to having that view though and it’s worth reminding ourselves occasionally what assumptions we have to make to invest in a passive manager.

If I told you that you should invest millions of pounds into a bond or equity issued by a company, but that there was no need to do any analysis of the risks, opportunities or even look at the company’s past financial statements, you might think me reckless. Yet this is exactly what you do when you invest in an index-tracking product. An investor in these products has no agent or fiduciary who is employed to perform due diligence on the companies held in the portfolio. There are plenty of reasons in favour of index-tracking but having no one perform any analysis on the assets is, for me, a brave step.

Why do passive investors need to believe active management works?

Index-tracking products rely on others to do all the analysis. These ‘others’ – active professional investment managers and individual investors – each have a different view of the company’s worth after doing their analysis. Their assessment and willingness to buy and sell the company’s shares and bonds at different prices drive the quote on the stock exchange, and the price that you, as an index-tracking investor, passively accept when you invest.

An index-tracking investor should believe that all these other players are, in aggregate, sufficiently skilled so that the price of a company reflects the best estimate of its value after assessing all the risks the company is exposed to and the opportunities available to it.

To be clear, the best estimate of its value available may still be “wrong” – the share price may fall, or rise, substantially because of things that were not foreseen – best estimate just means no individual can consistently be more accurate with their valuation.

If the market price is not a good estimate of the value of the security issued by the company, then an index-tracking investor is exposed to a risk of capital loss. The price you pay for the portfolio of shares in the index could be substantially higher than they are worth; or substantially lower than they are worth when you come to sell.

An index-tracking investor must believe active managers are really rather good at their jobs to reasonably believe they are not exposing themselves to this risk.

So, for me, the burden of proof here lies with the passive managers: I need to actively believe that passive investing is appropriate in an asset class; not merely that active management is unlikely to add value.

LCP viewpoint

My view is that index-tracking remains appropriate in developed market equities and G7 government bonds.

Matt Gibson, Partner, LCP

So what does the evidence suggest?

Are active managers generally pretty good at assessing the value of securities?

Many studies have shown that in US large-cap equities the average actively managed fund, after fees, does not outperform index-tracking funds. This isn’t that surprising: all investors who don’t track the index are ‘active’ in some form. Since the index-tracking return is the average return available, asset-weighted, half of the active investors will return less than the index and half will return more than it.

This isn’t enough to convince me index-tracking is appropriate.

If active managers as a whole were not skilled at their jobs and were not finding that best-estimate price, then some particularly skilled active players would be able to outperform consistently – and beyond the number we might expect from chance alone.

Research by S&P Global suggests that consistent returns by managers in US equities is rare. This gives us comfort that, in this market at least, index-tracking remains a reasonable investment approach. Similar results are found in most developed equity markets.

The picture, though, could change. There has been a huge growth in passively managed assets; and a commensurate fall in actively managed assets.

Is there a point where there are too few skilled active investors to be adequately assessing companies’ risks and opportunities? It seems unlikely to me that we are that close to this point for developed equity markets quite yet - the total proportion of the US equity market that is run passively is estimated still to be less than 20%. If we do get there, though, it won’t be apparent in performance data until some time after.

My view is that index-tracking remains appropriate in developed market equities and G7 government bonds.

The decision is more finely balanced in corporate bond markets, where there is some evidence that a group of active bond managers can outperform.

In emerging market equity and bonds, I would generally advocate an actively managed approach. There is little evidence available here to confirm that active managers struggle to give persistent outperformance.

There are reasons other than the efficiency of the market that tip the balance in favour of an active approach in some asset classes. Some indices may provide a concentrated exposure to a sector or country and you may wish to have a more diversified exposure through active management. Some indices do not reflect the full opportunity set well. Most popular emerging market debt indices, for example, cover only a small proportion of the total available universe of bonds.

Conclusion

Index-tracking strategies have been very successful in many markets, providing a return at low cost that few active managers have beaten. You do, however, have to take a leap of faith that “the market” – these same active managers – are doing a good job at valuing the securities in the index in order to invest passively. This may not be the case in all asset classes.