The Passive Fallacy

The growth of passive investment strategies has been supported by a narrative that active management should be shunned in favour of the passive approaches which have disrupted the investment management landscape. We at Cerno remain ardent supporters of well-considered, properly implemented active approaches to investment. Our position is based on our own experience of investing and of our time spent observing active investment managers and the development of passive, or rules based approaches.

The potential rewards to a successfully implemented active investment strategy are significant and are perhaps best exhibited through the example of a savings plan for a new born child. Assuming the parent of a child born in 2016 is willing to make the requisite JISA and ISA contributions and that child is subsequently able to continue with contributions to the age of 65, the uplift from an active approach results in a potential doubling of income in retirement. Chart 1 demonstrates this clearly by assuming a 4% nominal annualised return from a passive approach and a 6% nominal annualised return from an actively managed approach. These assumptions compare with the average return assumption of 7.6% taken by US Public Pension Plans.

These assumptions appear reasonable and correspond with our own experiences: the 2% uplift in return assumption from active management corresponds with the aggregate (net of fees) excess return generated by the Cerno Capital list of approved third party managers while the 6% assumption closely mirrors the return since inception of our core multi-asset strategy.
Chart 1: The Power of Active – JISA to ISA
Power of Active
Source: Bloomberg

Alliance Bernstein[1] has recently observed that the introduction of cheap factor driven strategies, typically called Smart Beta, has destroyed any clear differentiation between active and passive. While this stance has some attractions, we believe that we can be clear in defining active and passive approaches as follows:

An active investor will use skill, analysis and judgement to build a portfolio of investments which are expected to deliver an attractive rate of return. The active investor will also avoid investments which are believed to offer unattractive returns or where the potential return is not understood.

Meanwhile, the passive investor defines the asset classes and sectors to invest in (the universe) and then allocates client capital to all investments in that universe. This is typically achieved by investing according to weights set in publically available indices. The passive investor makes no considered assessment of the underlying fundamentals of any individual equity or bond that is bought other than to check that it is included in the relevant index. The passive investor therefore does not care whether his client’s capital is placed in a “good” or “bad” investments in terms of expected return.

The challenge for someone wishing to invest passively is how to deal with the many investment decisions that need to be made in a diversified portfolio. For example;

  • Which asset classes to include?
  • What is the correct allocation to each asset class?
  • Which is the correct index for each asset class?
  • How is the index constructed (not all indices are as passive as they seem)?

Chart 2 highlights a typical challenge for the passive investor. The blue line is the FTSE 100 that might be used to track UK equities. But this index is globally facing and concentrated in Energy, Banks, Telecoms and Pharmaceuticals. What about all those great industrial businesses in the UK? Perhaps a more representative index would be the FTSE 250 which has compounded at 8.4% per annum versus 4% per annum for the FTSE 100. This is a huge differential when compounded over a long period. Thus we find two UK equity indices providing two very different investment outcomes.

Chart 2: Which Index?
100 vs 250
Source: Bloomberg

The passive investor faces similar choices in Fixed Income. The challenges of being passive within one asset class are very evident, but perhaps not insurmountable providing the investor is willing to compromise on potential return. The next challenge is to define a passive approach to allocating between asset classes. Our observation is that the typical approach is to set an allocation based on observation of historical returns and volatilities. Such a backward-looking approach seems at odds with the standard disclaimer “Past performance is not a guide to future returns”.

Our conclusion is that it is impossible to be a truly passive investor or lender as all portfolios need some human judgement. What is clear is that it is possible to be passive in individual asset classes and the exchange traded funds and passive unit trusts offered by passive fund providers form a useful part of the active investor’s toolkit, for example when a short term market opportunity is presented and a simple allocation to the broad market will capture the opportunity effectively.

Passive has gained most traction in the management of equity portfolios. This is to be expected as the earliest index tracking fund was developed to track the Dow Jones Industrials 30 Index. This was followed in 1975 by John Bogle’s Vanguard 500 Index Fund which tracks the S&P500. By 1999, this vehicle managed $100bn. It is within the field of equity portfolio management that there has been most analysis of the ability of investment managers to deliver net of fees performance in excess of a relevant benchmark.

The argument for passive goes along the lines that the majority of equity funds under perform their benchmark index. The small number that do deliver outperformance fail to do so consistently, year in year out. Therefore there is no point in trying to find the ones that do.

The academic backing for this stance is strong. Countless studies show that in most peer groups of equity funds, the average manager underperforms the index.

We would not disagree with this conclusion – if we are scientific and include all relevant data, it is a racing certainty that the average manager will underperform after costs. However, is it not odd to be interested in the average manager?  Surely we should be interested in excellent investors? When was the last time an average tennis player won Wimbledon? The more important question is first; are there any managers who deliver net of fees returns in excess of an appropriate index, and second; can we observe commonly recurring characteristics that would allow is to identify them on an ex ante basis?

We can certainly identify the managers with a high probability of producing an average or market like return by looking at their portfolios and working out how much overlap there is with the index. A high level of overlap means the portfolio is unlikely to perform very differently to the index and is therefore not interesting. The name of this measure is active share and a score above 70% is indicative of a highly active portfolio, although allowances must be made for highly concentrated markets such as the UK and Australia where values will be lower. The average score for the equity managers on the Cerno approved list is 90%.

It must be acknowledged that to perform differently to an index, a portfolio needs to be invested differently to that index. The use of active share allows us to make a naive assessment of an investors approach to portfolio construction and to observe whether it is constructed to allow it to perform. We must remember that high active share will not of itself lead to positive returns.

So, if we strip away the closet trackers, what are we left with?

A simple screen of the Morningstar database shows that of the US Equity Funds with a 20 year track record to the end of March 2016, twenty percent have delivered a compound annual return in excess of the S&P500 over the full twenty years. This figure will overstate the true number of funds that outperform given survivorship bias. This analyst’s rule of thumb for the likely opportunity set of skilled investment managers in a given peer group has always been ten percent.

While manager returns can be observed on an ex poste basis, the more important question is whether managers with a high probability of success can be observed on an ex ante basis. Our response is that they can. There are key characteristics that we see repeatedly across excellent investors. The first characteristic is one that surprises many casual observers of the investment problem. When investing in companies or buildings or lending money “active” should not imply activity. The ability to trade successfully and the ability to invest rarely reside in the same person or team. Excellent investors are patient, methodical people who think about the development of a business in terms of years rather than the development of a share price over minutes. Contrast this with the quick minded trader, taking advantage of market psychology on the demand and supply of paper assets. While the popular image of an investment floor involves Bloomberg terminals, flashing lights, phones tucked into bent necks and much shouting, the truth is that excellent investors typically operate in an environment not dissimilar to a library. A number of the great investment teams we follow boast of the absence of Bloomberg terminals on their investment floors.

The result of in depth, patient, fundamental analysis is that excellent investors tend to own companies for many years and often decades. Portfolios can be easily examined to confirm this.

There is academic evidence to support the idea that the pool of patient investors who build idiosyncratic portfolios is an attractive pool for the manager researcher to fish. In their December 2015 paper; Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently, Cremers and Pareek[2] show that a group of US equity managers selected purely on the basis of long duration of holdings and high active share outperformed the S&P by a little over two percent per annum over the twenty year measurement period.

Turnover can be used as a proxy for the patience of an investor although it is not the same thing as duration of holdings and the Cremers and Pareek study does not support its use in place of holding period. High turnover is not necessarily a bad thing, but we tend to be suspicious when we see it.

While portfolio construction (active share) and duration of holdings are quantitative metrics that help define a universe of managers with performance potential, a qualitative approach which focuses on understanding an investment approach and determining soft factors will improve the chances of selecting an investment manager with a high probability of delivering strong performance.

We have observed that investors who can articulate their investment approach clearly and succinctly have typically invested considerable effort into formulating their approach and are therefore well placed to remain committed to the approach during periods of cyclical underperformance. Of course, the manager researcher must have a reasonable understanding of the asset class to be able to determine whether or not the chosen approach is appropriate for the asset class. Moving away from investment strategy, we have observed that the operating environment in which an investor or team sits is a key determinant of success. Investment teams that own the business within which they operate are typically more aligned with clients than hired guns. These investors are also in a position to control the quantum of assets they manage to ensure weight of assets does not erode performance potential as it tends to do when a business is driven by the sales team.

The obvious route here is to direct interest toward boutique investment firms which typically focus on one core strategy in which the founders are long-in-the-tooth specialists. However, the boutique founders of tomorrow may be operating in large organisations today; hence it is important to maintain some coverage of the larger firms to be in a position to move early into boutiques. In addition, there are skilled investors who have found they operate more effectively with the infrastructure of a large organisation and have built a franchise that gives them protected status. As we assess a fund management organisation, the corporate structure adopted is relevant. For example it is easy to contrast the time horizons of the partnership with a listed business and one can observe a very different targets and incentives given to investment professionals.

Finally, we must return to the observation that active investors that do generate outperformance do not do so consistently, year after year. Once again, we must shout “of course they don’t!”

We have established that excellent investors have a clearly articulated investment approach to which they are committed. If these active managers are disciplined and stick to their approach they should deliver attractive returns in excess of any appropriate index over a reasonable time-frame. However, over short periods, stylistic factors come into play. In other words, the approach is either in vogue or not and when it is not, short term performance will likely lag the index. The key takeaway is that relative performance is cyclical. This cyclicality is caused by the preferences of the investment manager which can manifest themselves in sector biases, for example some managers prefer consumer facing businesses over industrials while others are drawn to asset light services businesses and ignore asset rich utilities. Cyclicality is often caused by style with periodic dispersion between value and growth being the most well observed. Chart 3 highlights the prolonged underperformance of value versus growth that began in 2007. Anyone looking at a manager with a deep value bias today should expect to find underperformance and should be wary of managers describing a deep value philosophy while presenting exceptional recent performance.
Chart 3: Style Drives Relative Return CyclicalityStyle Drives Relative Return CyclicalitySource: Bank Credit Analyst

A failure to appreciate the cyclicality of performance will result in the most common mistake made by fund allocators – buying after strong relative performance and selling after poor relative performance. The buy high, sell low phenomenon is the trap that awaits anyone using performance screens to choose managers. Never ignore the disclaimer: “Past performance is not a guide to future returns”. Historic returns data has only one use – to test the allocator’s knowledge of the investment strategy. If the track record is not understandable given knowledge of the approach, get rid of the manager regardless of whether the track record shows good or bad performance.

Chart 4 demonstrates the patience required of the clients of successful active managers. The chart plots the rolling three year annualised excess return of the IVI European Equity Fund. Over the period, the fund has delivered an attractive average three year annualised excess return of 2.4% per annum. However, to achieve this return, the client has enjoyed a period of great joy and then was perhaps tested in 2014 when the three year number declined to -3% per annum, since when the relative numbers have returned to an upward trend. The message is clear, once a good manager is identified; it pays to stick with them.

Chart 4: Relative Return Cyclicality

Relative Return Cyclicality

Conclusion

The debate between supporters of active and passive investment management will undoubtedly rumble on. Meanwhile, a select group of active managers will continue to deliver benchmark crushing returns for their clients and asset allocators with adhering to the principals outlined here will continue to benefit from the investment skill of this group. To recap, by constraining the search to truly active managers with a long term perspective; who are committed to their discipline and by understanding the manager’s operating environment, the asset allocator stands a better than average chance of selecting funds which can be held for prolonged periods of time and thereby compound returns to create real wealth for clients. By way of a proof statement, the results of Cerno Capital’s approved list managers are shown below. The excess return generated by our list correlated with the 2% outperformance assumed in Chart 1.

Chart 5: Cerno Capital Approved List Performance
Cerno Capital Approved List Performance
Source: Cerno Capital


[1] Alliance Bernstein, “In Defence of Active Management”, May 2016

[2] Cremers & Pareek, “Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently”, December 2015

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By |2016-09-06T13:18:00+00:00September 6th, 2016|Asset Class Returns, Cerno Capital Posts, Other Posts|

About the Author:

Fergus surveys the full range of the firm’s investments on a bottom up basis and is principally engaged in manager and security selection. He began his investment career at Valu-Trac Investment Management in 1995, where he worked in their global equity and asset allocation products. He worked for Russell Investments as a Portfolio Manager of UK equities (2001-2006) and Asian equities (2006-2009). Fergus graduated from Edinburgh University with a BCom (Hons), holds the CFA charter and is a member of the CFA Society of the UK. Fergus is a Director of the Salters’ Management Company.