I was asked to speak at a seminar put on by a big fund management group this week. I was to talk about the pros and cons of ‘active’ and ‘passive’ investing and give the ‘final answer’ on which serves investors best.
This was a pretty brave call from a firm devoted to active management, given the stand MoneyWeek has taken over the years on fund-manager overcharging and incompetence. But it wasn’t quite as bad as you might think – mostly because there isn’t really any such thing as passive investing.
When you put money into any sort of index tracker, you make two big, active decisions along the way.
You decide on your asset allocation – are you going to have your money in Japan? Britain? In commodities? In emerging-market bonds? If you bought a big global investment trust, these decisions would be taken out of your hands, but if you go ‘passive’, you decide them yourself.
But that’s not the only decision you make. When you go passive, you are by default making a huge strategic move. You’re deciding that your money will be invested according to a momentum-based market-capitalisation strategy: the way indices are constructed means you end up holding more expensive stocks going up in price, and less cheap stocks going down in price. That’s not normally considered a good idea.
We looked at this in the magazine a few weeks ago and there’s more here about the pitfalls of traditional passive investing and a potentially better way to do it – buying all the stocks on an index using different measures such as dividends or sales ratios to weight them, perhaps.
But speaking about it again made me think about what kind of manager should make one want to buy an actively managed investment fund. History appears to offer a couple of answers.
First, a manager must be clever and consistent. He must choose a proven strategy and stick to it (back-testing shows that if you weight an index based on sales, for example, you get better returns than with market capitalisation). So he must have a high boredom threshold.
He must also be uninterested in benchmarks – research has shown that the more differentiated from an index a portfolio is, the more likely it is to outperform. Contrarianism works.
And crucially, he must be cheap. He must keep costs low – in particular he must not buy and sell very often. And his management fee must be low.
I wonder if we might all do better if we made all active fund managers part-time. That would give them less time to trade. Less time knocking around the City agreeing on return-leeching consensus investments with all the other managers, and more time with their families. Less reason to charge us such high fees (this is crucial) and, if history is anything to go by, better returns as a result. Win win?