The differences between active and passive managers may seem obvious, but investors would do well to ignore headline figures and dig deeper, Emma Cusworth says.
“Over the long-term, the average active manager is the market-cap benchmark because all the active trades in the market add up to create the benchmark movement.”
Cai Rees
The age-old debate about active versus passive is once again in full swing. That’s a good thing if it means investors are picking managers and strategies with their eyes more open than they were before, but if the data is misinterpreted, the resulting damage could be meaningfully greater.
Much of the argument in the active/passive debate focuses on how few active managers outperform market benchmarks over the long term. The easy conclusion to draw from this headline figure is that active management is bad and passive funds are the way to go.
However, the answer is not that simple. Much of what the data shows is intuitive and the simple conclusion of ‘active is bad’ misses a few fundamental points.
SHOULDN’T ACTIVE OUTPERFORM?
Of course. Why else would you pay them, right? Not quite. The average manager cannot outperform a market-capitalisation weighted benchmark because, as Cai Rees, client investment strategist at SEI Investments says: “Over the long-term, the average active manager is the market-cap benchmark because all the active trades in the market add up to create the benchmark movement.”
Put simply, if a benchmark had only two stocks that were the same value on day one, a passive strategy would allocate equally to both companies and both companies would have the same price all the time. “That’s not capitalism,” Rees says.
Capitalism – especially the kind end beneficiaries would want their investing representatives to be involved with in the long-term – means making a judgement about which of those two companies is better and overweighting that stock. Thereby, ‘good’ companies are better able to survive and prosper, which means the economy will grow in the long term, creating value for end investors. Only by making those active, relative judgements will a market-cap benchmark move.
Of course, nobody tries to select the average manager. Everybody wants to find the small number of managers that will outperform over time. That is easier said than done.
The 2015 year-end Europe S&P Indices Versus Active Funds (SPIVA) Scorecard shows active managers overwhelmingly fail to outperform benchmarks over three, five and 10 years. Nearly 90% of managers are beaten by the benchmark over 10 years (see chart inset), but even by three years more than half (roughly 65%) will be underperforming and around 80% will do so by five years.
This sits in stark contrast to the ‘average manager is the benchmark’ argument, which should set off alarm bells for anyone taking this data at face value. How can 90% of managers underperform the average? The other 10% must be doing remarkably well…
WEIGHING UP RETURNS
But, the SPIVA chart is also equally weighted. It looks at the number of funds out or under performing rather than the amount of assets that are doing so. On that basis, it is intuitive that more funds would be underperforming for the simple reason that ‘good’ funds – those that are able to consistently deliver outperformance – attract more assets and stand a better chance of survival in the long term than ‘bad’ funds. Each year across Europe tens, if not hundreds of new funds, are launched and a huge proportion of those will not last a decade because they have liquidated or merged.
Survivorship rates over 10 years are not great. UK equity funds, for example, have only a 45% survivorship rate. Netherlands equity is particularly tough, with only 23% still going, while emerging markets equity is 67%.
The SPIVA data underlying the chart treats fund closures as underperforming funds “as they have tended to perform poorly”, according to an S&P spokesperson. This is intuitive, of course, but it does skew the data towards underperforming funds on an equally weighted basis.
This is very helpful in highlighting just how difficult a task it is to select the few funds that have the skill and durability to outperform over 10 years. Importantly, however, it doesn’t mean that 90% of the assets invested with active managers would have been beaten by a market benchmark over 10 years.
As S&P’s report points out: “Beyond the SPIVA scorecard’s widely cited headline numbers is a rich data set that addresses issues related to measurement techniques, universe composition, and fund survivorship that are less frequently discussed, but are often more fascinating.” It goes on to say: “An accurate representation of how investors fared in a particular period can be ascertained by calculating weighted average returns where each fund’s return is weighted by net assets.”
On an asset-weighted basis, for example, 10-year annualised returns for Europe equity funds net of fees are 8.89% – 1.85% better than on an equally weighted basis (7.04%). Over 10 years that 18.5% difference becomes very meaningful – and that is still at the ‘average’ manager level. Unfortunately, S&P doesn’t provide comparative analysis of assetweighted returns relative to market-cap benchmarks as it does for equally-weighted returns.
To some degree this might seem counterintuitive – smaller, hungrier, more nimble funds should be better able to outperform, right? In the short-term, perhaps, but over the long term the correlation between AUM and outperformance is intuitive.
As Yves Choueifaty, president of Tobam says: “It’s very difficult to find a fund that consistently underperforms as they die off. If they achieve the opposite result, they attract more assets and become enormous.” S&P’s director of global research and design, Daniel Ung, says their analysis shows “where there are lots of assets under management, those categories tend to outperform as well.”
CONTEXT IS VITAL
The move to defined contribution (DC) pension structures could make the difference between the two weighting systems even more marked in the future.
“In the new world of DC people vote with their feet,” says Mercer partner Brian Henderson. “Because the numbers are very visible and retail investors often lack the same level of advice as institutional investors to provide the context to returns, managers will increasingly live and die by the numbers.”
This sets a gloomy picture for the future return expectations of generations of pensions savers. If they succumb to performance chasing, it will mean investors miss out on some of the best returns on a rolling basis, which will add up to a huge cumulative opportunity cost.
Analysis from SEI shows top quartile performing managers over five years have a 34% likelihood of ending up in the bottom quartile over the next five years – the most likely outcome.
“Those that came from the bottom are more likely to be in the top quartile in the next period,” SEI’s Rees says. “Looking at past performance out of context is not useful in picking managers that will outperform in the future.”
HEADLINE ACTS
The move to DC will also likely increase the tendency to focus on headline numbers, which, in the long-term will do further damage if the swing towards passive management continues. While the proportion of passive to active money is not yet materially affecting how markets operate (although this is an arguable point), the ultimate effect of an increasing weight of passive money is twofold.
First, long-term economic growth becomes harder to generate as money is not being allocated in a truly capitalist manner (giving more capital to companies are are more likely to prosper in the long-term) and fewer active bets will lead to greater volatility in passive benchmarks, which works to the detriment of all investors, active and passive alike.
PwC predicts the rate of growth in passive mutual funds and mandates will grow much faster than their active counterparts. Their figures show the share of global AUM in passive strategies rising from 11% in 2012 to 22.7% in 2020, while active will shrink from 79% to 65% over the same period.
But does passive outperform market-cap benchmarks? Quite the opposite. If the chart included a line to show the proportion of passive managers underperforming benchmarks, the line would run pretty much horizontally along the 100% level. A pure-play passive manager fully replicating a benchmark will perfectly match the benchmark returns minus fees and costs. As such, that simple metric tells us very little about the relative performance of active and passive managers.
WHAT’LL IT COST?
No discussion of active/passive is complete without a look at fees and, of course, active fees are typically several multiples of passive fees. S&P research shows average annual expense ratios for European equities, for example, are 1.88% for active funds and 0.34% for passive funds – a 1.54% difference that creates a 7.36% drag on performance over five years. That’s a high hurdle for active managers to achieve.
And the average manager is failing to beat a benchmark on this basis. S&P’s data shows, on an asset-weighted basis, Europe equity funds returned 8.94% per year over five years while the benchmark returned 9.63%, leaving active managers with a negative differential of 0.69%. Interestingly, however, Europe large cap managers generated a 0.46% positive excess return versus their benchmarks while mid- and small-cap managers generated a shortfall of 1.49%.
The fees included in the study are also set at the headline rate for each share class of a fund. They do not reflect the discounts available to institutions, particularly those with a lot of assets to allocate and, as such, the figures suggest returns are worse than many institutional investors would experience in reality.
Stephen Miles, global head of equities at Willis Towers Watson (WTW) says: “If you negotiate the fees, the percentages over 10 years become much better.”
Although bespoke fees are dependent on the bargaining power of the buyer and are therefore difficult to generalise in average terms, Miles says: “In the institutional world a very large buyer getting less than half of the standard fees is sometimes possible.”
Active management fees have also come down markedly over the last few years. The average annual expense ratio for Europe equities, for example, fell at a compound annual rate of 2.15% per year between 2010 and 2014.
Clearly, if active managers want to compete with their passive brethren to maintain market share, there is still room for further fee reductions or a restructuring of fees that moves away from management fees that are charged regardless of returns in favour of performance related pay. Meanwhile, if investors continue to push hard for change, they will be more able to swing the chances of outperforming benchmarks further in their favour.
The number of active managers able to outperform a market-cap benchmark after fees is not, in fact as dire as the headline figures might suggest, but active managers have some work to do in making a stronger case for their ability to add value, especially given the habit investors have of comparing their performance to market-cap benchmarks. Fees are an area where further improvement is desperately needed. That said, investors need to avoid the temptation to focus on headline figures that can be misleading if they are not properly interpreted. More robust investigation is imperative to understand the value active managers can offer. Without that, investors could end up allowing a prejudice to disadvantage their end beneficiaries.
As WTW’s Miles says: “All of this discussion is worthwhile to raise education, but the main takeaway is be careful what conclusions you jump to. Use of active managers is still an area were many investors are not that informed how best to do it, even though it can have a big impact on financial outcomes. Informed buyers are more able to tilt the odds in their favour.”
