New evidence in passive vs active investment debate

UBS looks at the performance of funds in Europe over a 20 year period
Thursday 09 Nov 2017 Author: Steven Frazer

There is new evidence that firmly supports actively managed funds in the passive versus active debate.

Investment bank UBS has analysed the performance of more than 27,000 mutual funds in Europe over the past 20 years. It found active managers have collectively outperformed their benchmark after fees by average 0.42% per year since 2000.

That figure rises to 0.78% outperformance per year when comparing after-fee returns to their passive competition rather than benchmark. We’ll explain what all those terms mean in
a second.

A reminder about the debate

A dispute has raged for years over which type of investment delivers the better overall returns for investors: active or passive?

Passive investment means buying a vehicle such as a tracker fund or exchange-traded fund (ETF) which mirrors the performance of a broad cross section of the market or perhaps a specific industry or geography. Good examples include a FTSE 100 tracker fund or an emerging markets-based ETF.

Active investment involves a fund manager hand-picking stocks, bonds, property or other assets; with portfolio weightings that match their investment objectives. The most ubiquitous styles of active management include value, quality and momentum.

The aim of active management is to outperform a benchmark such as a specific stock market index.

Fees, fees, fees

One of the biggest criticisms of active management is the higher fees compared to passive investments. Subsequently, there is widespread belief that passive investments equal lower costs and better performance.

Global passive assets are set to more than double from $14trn in 2016 to $37trn by 2025, according to a recent report from professional services firm PwC, emphasising their growing popularity.

Some industry observers have even speculated on the demise of active portfolio management completely.

Analysts at UBS beg to differ, saying the belief that active funds underperform benchmarks ‘is a myth… even after fees’.

Active performance isn't universal

When it comes to outperformance, not every strategy is equal. For example, UBS found that European actively-managed funds focused on US and global investment strategies (about one third of the total assets under management) have underperformed their benchmark and the performance of passive products since the financial crisis.

The real discussion

The debate really boils down to market efficiency. In essence, it might be described as the degree to which all publicly available information is already reflected in a security’s price.

In theory, the more efficient a given market is, the harder it is to outperform the simple strategy of holding a passive basket of all the securities in it.

But while the market may be completely efficient some of the time, and reasonably efficient most of the time, it isn’t completely efficient all of the time as market structure and participant supply/demand characteristics change.

It is on these sometime inefficiencies that active managers hope to capitalise. One way of doing this is to specialise and become a relative expert in a niche. Many fund managers do this by concentrating on a particular sector, geography or style.

Private investors often do this too, typically concentrating on smaller companies, where professional research is limited. Some stocks are priced incorrectly because most investors don’t know these companies exist or don’t properly understand the story.

The UBS report comments: ‘We found more focused and specialised funds are more likely, as a group, to generate alpha.’ Alpha describes the excess returns of a fund relative to the return of a benchmark index.

Moving the discussion on

On the surface, it would seem that investors are migrating toward passive strategies. Yet investors are increasingly using both active and passive products as tactical bets. This might be to provide hedging, gain from sector rotation strategies or boost a portfolio’s exposure to emerging markets, for example.

‘It is important to remember that in a rising market passive returns are very attractive at low cost but that inevitable market corrections will bring a continued appreciation for the value of active investments,’ says PwC’s Olwyn Alexander, leader of its global asset and wealth management team.

‘Both will be key building blocks in balanced portfolios to meet specific investor outcomes.’

We don’t expect arguments over passive or active investment to stop anytime soon. But perhaps a more productive debate for investors would be deciding how much of your optimal portfolio should be in active or passive investments. (SF)

Why passive funds can underperform a benchmark

They experience tracking error as they cannot perfectly match the performance of the benchmark. This tracking error is greatest in periods where constituents are added and/or removed from a benchmark.

Passive funds charge fees to cover the administration of the fund’s assets, transactional costs and management fees. As a result, in a perfect world, where there is no tracking error, passive funds will always underperform their benchmark due to these costs.

Source: UBS


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