Active versus passive nears tipping point
As many market indices have romped to all-time highs, faith in active managers to relatively outperform is being tested. But Walter Scott Investment Management argues increasing allocation to passive funds poses a number of potential problems over the long term.
Prior to the 2008 crisis, passive funds were largely a side-show, with the exception of ‘boom’ periods, such as those ahead of the technology and global financial crashes.
However, the market’s memory is like that of a goldfish and as the current bull market has accelerated, demand for tracker funds and their symbiotic derivative cousins, exchange-traded funds, has exploded.
One reason for the popularity of trackers is their tendency to be widely diversified. As Warren Buffett said, "diversification is protection against ignorance". Another contributing factor has been the inability of many active managers to beat their comparative indices.
Although it may be mathematically impossible for more than about 30% of active managers to beat the market long-term, recently, an unusually large percentage has suffered nearer-term underperformance. This ‘failure’ needs a context, however, as passive funds must always underperform their indices.
‘Active’ underperformance explained
Two obvious reasons for this widespread underperformance are the plentiful monetary-easing measures being taken across many G20 nations and the suppression of interest rates to record lows. This has, at times, resulted in the propping up of weak or ‘zombie’ companies, or bad businesses which have taken on unprecedented leverage or debt. The share prices of both groups have soared like eagles, even though the smallest change in demand, credit availability or interest rates will result in their destruction. No true value manager could consider such businesses, in our opinion.
The longer a trend persists, the more dangerous it becomes. Therefore, we believe it makes sense to invest actively in an attempt to benefit from the herd-like behaviour of others.
Flaws in the classification of managers pose another problem; many managers like to be classified as ‘active’ as a way to justify (now marginally) higher fees. This means the ‘active’ category can include managers who never stray more than a few basis points from an index and myriad proto-trackers whose portfolios mirror the index remarkably, save for a rump which churns like a washing machine, desperately seeking ‘alpha’. Hence, these managers own Apple, the largest company in the world, worth what we consider to be an unsustainable US $800bn. True stock pickers might not.
Passive’s hollow shell
In The Wizard of Oz, Dorothy approached the Emerald City with wonder, only to discover it was a hollow shell. Similarly, investors have wondered at the seemingly failsafe returns from passive funds. In contrast, an objective alien such as Mr Spock would conclude passive investors suffer deep self-loathing, as their funds are forced to buy after prices have risen and to sell after they have fallen.
A significant barrier to intelligent investment has been the Efficient Market Hypothesis and similar theories that have become enshrined as market wisdom. Essentially, these concepts state share prices incorporate all relevant information and investors always behave rationally, therefore it is impossible to identify under- or overvalued companies as a way to add value. Passive funds are the offspring of this flawed theory, happily investing in businesses irrespective of their worth.
Inherent within tracker funds are curious assumptions: indices will forever rise, today's winners will remain on top and the growth of the largest companies is limitless. Yet a (theoretical) investor in 1928 in a fund tracking the Dow Jones Industrial index (well before the crash) did not see the same price repeat until 1951. After the utilities index commenced, 1930s’ investors flocked to its perceived safety. They had to wait 40 years to see the same nominal value in real terms, in 1970. (Shortly thereafter, the index halved). Another example is the FTSE 30 index, once the broadest measure of the best British companies. Of the original stocks listed 40 years ago, only four remained in 2002. The other 26 went bankrupt or were taken over after eye-watering losses.
The clear lesson from past market downturns is that they always catch investors by surprise. Administration departments in the financial sector then struggle while liquidity risks are under-estimated. This liquidity risk has worsened because investment banks have become more risk-averse and shrunk their trading books to concentrate on the largest and most liquid stocks only. These dominate passive-fund investments. Therefore, in a downturn, the effects of this lesser liquidity will magnify falls. Much passive investment is automated. It is bad enough when humans panic, but when machines join in, passive investors will suffer from automatic triggers; the active manager has choices.
There is a tipping point for all investment strategies; the greater the success, the larger the number of imitators. Academic research suggests this tipping point occurs when around 20% of investors follow the same strategy – a level that has been reached in some lesser-traded government and corporate-bond markets and smaller equity markets. Therefore, passive investors and their automated dealing activity may become too large to sell in an orderly fashion, which could make downturns unnecessarily extreme. Yet perversely, the more funds flow into passive vehicles, the greater the opportunities for active managers to benefit from sheep-like behaviour.
A crucial role for investment success is ‘price discovery’: to find businesses whose true value is not reflected in the share price. Passive investors have not only given up on this and the considerable potential gains, but have also made a positive choice to invest in companies which could be considered overpriced or may fail. Now they are also making some extreme "active calls" as money continues to flood in.
The cyclically adjusted price-to-earnings ratio (better known as CAPE) on the widely used S&P 500 index is well into the top decile. The forward multiple is higher today than in 94% of its history. Thus, buying a broad US tracker involves a positive, not to say controversial, decision to buy at a near-record high.
Managers with a concentrated portfolio of appropriately valued companies making long-term decisions and pursuing a systematic logical policy can win, despite periods of weak performance. It is right that investment returns are probed and compared with benchmarks over a market cycle. As some leading indices have once again reached extreme levels, so the challenge for active managers is clear.
Meanwhile, for as long as the money flows into passive funds, they must continue to buy the good, the bad and the very ugly under the irrational assumption that big is safe and liquidity is a permanent fixture. The next correction will once again expose these self-evident flaws and their structure as a triumph of despair.This is not investment advice. Regulatory Disclosure