Active vs Passive: the good, the bad and the average
For much of the past decade, there has been a rise in the use of passive investments at the expense of actively managed funds, principally driven by lower costs. The idea behind passive investing is that the investor removes the decision making (and cost) over which stocks to buy. Instead they invest in the shares that make up an entire index, e.g. the FTSE 100, and so own shares in every company in that index at the respective weighting. So, is this a clever idea? Unlike many on this subjective, we are not dogmatic and use both approaches within our client portfolios. The aim of this piece is to consider the implications of this move and how this has affected how we think about these passive investment vehicles.
The stock market is full of jargon but, at its heart, it can be thought of like an auction room. Instead of goods being sold by auctioneers, market makers offer stocks to the room and competing bids then discover the “correct” price. As any viewer of daytime TV auction shows can attest, the prices achieved can vary greatly between auction rooms and sometimes bidders can lose their heads and get carried away. Our approach to passives can be thought of in a comparable way; when the market shows signs of insanity, collectively over paying for shares, then it is not a market we want to track passively.
As pragmatic investors, we recognise that there are times where we would look to buy passive investments. However, in our view this is not the time, given that we are into the ninth year of this bull market and monetary policy is normalizing; we would prefer a bias towards active management. An active approach is likely to yield better results in a challenging market. This is because active fund managers should pick better companies that tend to fall less during a bear market and have the ability to use cash as a risk management tool. Disciplined fund managers will tend to hold higher cash weightings towards the end of an investment cycle (and so possibly underperform) because opportunities are scarcer, and many stocks have been trading at or beyond their true value. We invest in a number of funds which have seen cash levels rising as the market has pushed ever higher, yet have still managed to keep pace with market returns.
One such fund is the Findlay Park American Fund which invests in US shares. Since the inception of the fund in 1988, there have been 26 quarters when the stock market has fallen. This fund has “outperformed” in 25 of those down quarters by losing less than the market and therefore will have lost less than the passive funds. This means Findlay Park needs to make less to recover because a fund that, say, loses 25%, mathematically, needs to recover by 33.3% to get back to where it started. Therefore, we consider that active management is a form of risk management, and in this environment, it is worth the extra costs. Happily, in Findlay Park’s case, they have also handsomely outperformed their indices and hence passive funds over the past 20 years.
Cost has been a key driver behind the popularity of passive investments and because there is no fund manager or investment process, the fees can be extremely low. Wanting to pay less for an investment is something we fully support, but the result is a holding which contains every company in a respective index: the good, the bad and the average. There is no risk control and during the good times this may not be a problem, after all “a rising tide lifts all boats”. However, when tougher environments occur, we personally would prefer not to be holding the bad or below average companies.
This is where stock dispersion becomes important. Early in the cycle when companies are cheap, the ensuing recovery lifts all stocks by similar amounts. Therefore, there is little need for risk management and a low opportunity to outperform through stock picking – the ideal environment for passives. Since the start of the current economic cycle, companies have been able to benefit from cheap debt as interest rates plunged during the global financial crisis. This enabled so called weaker companies, who may have borrowed too much, to survive on cheap debt. With the cost of this debt now rising these companies will find it more difficult to both service and refinance their debt. Balance sheets will come under more scrutiny and this should result in greater stock dispersion i.e. the performance differential between the good, average and bad companies will widen. Good active managers tend to thrive in high dispersion environments and we believe we have selected fund managers, like Findlay Park, that can add value over passives in the coming years.
When we invest in passives we know that the greatest amount of your money will be invested into those companies that tend to be the most expensive, and less of your money to those companies that appear to be the cheapest on a valuation basis. If all company valuations are low, this may not be a problem. However, when we look at technology stocks during the late 90’s boom and subsequent bust, and the financial stocks before and during the financial crisis, you can see how an investor may be taking on a risk they do not want or need – simply because the rest of the market has become irrational. Our preference right now is for active management but there will be a time when we will prefer more exposure to passive investments, particularly in more efficient markets such as US equities.
Duggie Hawkins, CFA
Senior Analyst – US Equities
This document may include forward-looking statements that are based upon our current opinions, expectations and projections. Investment markets and conditions can change rapidly, and as such the views and interpretations expressed should not be taken as statements of fact, nor should they be relied upon when making investment decisions. We undertake no obligation to update or revise any forward-looking statements and actual results could differ materially from those anticipated by any forward-looking statements.
Past performance is not a guide for future performance. The value of your investment can fall, and you may not get back the amount invested.
Compliance Code KN1357