Investors have debated the relative merits of active and passive investment for years but, as Emma Cusworth discovers, coming down on one side of the fence is far from simple.
“In the recent past passive has done well, but the proposal to switch to passive may have come at potentially one of the worst times in recent history.”
Chris Jones
There’s nothing worse than being in the wrong place at the wrong time. When it happens it is usually because it was done for the wrong reason, or because the analysis behind that reason was flawed. When it comes to choosing between active or passive management, the same rules apply.
Since the late 1990s a conflict has been fought between the ‘conventional’ approach to investment management, founded on asset allocation, public markets and simplicity, and the ‘endowment’ model, which emphasises active management and the use of illiquid, private assets.
The ability to avoid the excessive volatility of the public markets in a crisis was among the main rationales for the endowment approach. The events of 2008 and 2009 revealed huge failings in its ability to do so, however. Liquidity proved to be a particular problem. Although liquidity is typically overvalued, in a crisis event, such as the credit crunch, it becomes what Bob Maynard, chief investment officer of the Public Employee Retirement System of Idaho, calls a “pearl without price”. In liquidity terms, publicly-traded assets are naturally at a significant advantage.
“The capital markets are a complex, interactive, tightly coupled, and adaptive world,” according to Maynard, “but the best response is not automatically a complex, tightly organised, and highly opportunistic investment structure. That type of organisation is often more brittle, prone to cascading failure, and at best opaque to risk management, and it has liquidity, headline, resource and continuity risks.”
Following the financial crisis, many investors, disappointed by the lack of value delivered by their active managers, have begun to return to passive strategies. For the three-year period ending June 2013, over 60% of US large-cap growth and value managers in the Cambridge Associates Investment Manager Database under performed their respective Russell style benchmarks.
IS PASSIVE THE RIGHT PLACE?
“The inability of the median active manager to outperform public security indices after fees has been demonstrated time and again,” according to Maynard.
Last March, a study by Vanguard found the majority of investment managers in most asset classes underperformed their benchmark. Furthermore, the longer the period considered, the more managers fail to beat their benchmark. Using the data provided by Vanguard, Charles Stanley Pan Asset calculates the chances of choosing 11 managers (one in each of the asset classes considered by Vanguard’s study) which all outperformed their benchmark over five years is approximately 0.01%. The chance of less than half of these managers beating their benchmark is 92%.
Comments