Smashing the myth of active versus passive

The amount invested in passively managed share funds in America overtook active funds for the first time in 2019. This rekindled the long-running debate about which strategy is better - active or passive?

Passive funds, for example ETFs, simply track an index of shares such as the S&P 500 largest companies in America. They invest in all the shares in the index and make no active decisions about which individual shares to buy. Consequently, they tend to have lower charges, because they don't do extensive research to evaluate the companies they invest in.

In contrast, active funds try to beat the index by researching companies to find mispriced shares whose fundamental value is not yet realised. These stocks have the potential to achieve higher returns than the market. Due to the research involved, active funds usually cost more.

The fierce dispute over which approach is better has run for years but creates a binary view that is misleading. Closer examination reveals a more complex picture in which both approaches can complement each other.

Passiv versus aktiv

Passive investing is based on efficient market theory, which states that the prices of assets such as shares reflect all available information. Academics such as Eugene Fama said this implies that it is impossible to beat the market consistently where information is widely available. Charges therefore become the crucial factor and so low-cost index trackers are the most efficient way to invest.

Professor Andrew Clare, chair in asset management at London based Cass Business School, said the recent popularity of passive funds is due to the amount of evidence suggesting that efficient market theory is accurate and active managers cannot beat benchmarks, especially after fees, over the long term. Another factor is that investors have become increasingly cost conscious, he said.

But proponents of active investing believe there will always be opportunities to spot mispriced shares in one way or another and this ability to find anomalies justifies the extra cost.

Many also argue that active managers can react to new information faster than passive investors, enabling them to make extra returns or avoid market falls.

Geographical differences

In the 1960s and 1970s, active investing was the norm because there was much less information about corporations available, making it easier for managers to find mispriced stocks.

But as more information became available, they found it harder to beat the market - particularly in America, the most mature and information rich market. However, studies show that outside the US, including in Europe, active management still produces results, especially with careful manager selection.

Many wealth managers therefore now find that optimal portfolios mix passive where they are unlikely to beat the market, with active where there is more potential to outperform.

The debate continues

Recent research in favour of passive investing includes a 2016 study by S&P Dow Jones Indices, showing that about 90 percent of active managers failed to beat their indexes over one, five and 10-year periods, after fees. Also, in 2018, S&P showed that over 10 or 15 years, 80 percent or more of active managers across all categories underperformed their benchmarks.

In contrast, 2016 research by UBS used different methods to S&P's. It showed that active managers beat their passive competition by 0.78 percent a year, after fees, between 2000 and 2016.

Furthermore, a study by UK regulator the Financial Conduct Authority (FCA) found that active funds outperformed passive funds, net of fees, by between 0.84 and 1.2 percent a year since 2003.

Active factors

So where are active and passive approaches most useful?

A comprehensive 2019 study from the University of Zürich found that actives investing in non-US shares supplied more value than those investing in the US.

Markus Leippold, professor of financial engineering at University of Zürich, said: "Active manager outperformance depends on the maturity and competitiveness of the market. In less mature or less efficient markets, active managers tend to outperform index funds; and vice versa in more mature markets such as the US."

This tallies with other studies showing that actives struggle in the US. In contrast, the UK is a better spot for actives, especially for funds that invest in medium-sized companies (mid caps). For example, 2019 research by Morningstar showed that 78 percent of active UK mid-cap share funds beat passive returns over 10 years.

University of Zürich also found that actives tend to lag passives during periods of unexpected share price volatility but outperform in calmer markets. This suggests investors should stay in actives for the long term and understand that they may not beat the market in every period.

The university also found that higher fees do not mean better performance, so it recommends avoiding active funds with higher charges as these drag on performance. 

Investors should also beware funds with low "active share" - the percentage of stocks in their portfolio that differ from the index. These funds can market themselves as active and charge accordingly, but generate returns similar to their indices and often underperform after fees.

In contrast, funds with high active share - where the portfolio holdings differ significantly from the index - have tended to beat their indices. For example, analysis by fund manager Natixis shows that high active share strategies outperformed the S&P 500 over the long term.

Another key concept is "patient investment", in which active portfolio managers tend to keep funds for more than 24 months. Patient strategies have outperformed their benchmarks by 2.2 percent a year, according to work by academics Martijn Cremers and Antti Petajisto.