Weekly outlook

The uncomfortable truth about passive investing

By Tom Stevenson, 24 June 2009

The debate about whether active fund managers earn their keep refuses to lie down but index-tracking is not necessarily the solution.

The argument between the proponents of active and passive fund management has raged for 30 years of more, ever since the savage bear market of the 1970s prompted a rethink of then dominant investment methods. Back then, everyone was an active investor. Being in the stock market meant trying to beat it. All fund managers aimed to out-perform both the market index and fund managers from competing firms by picking better stocks. Then indexing came along and some investors decided that they would prefer to give up the chance of beating the market in exchange for lower costs. Passive fund managers don’t make decisions about which shares to buy and sell. They simply copy the performance of the relevant index by buying all the securities listed in it. Tracking the market like this accepts an average performance but it is much cheaper than stock-picking.

"Passive fund managers don’t make decisions about which shares to buy and sell." Tom Stevenson

There are two main arguments for passive investing. The first is that, although the benefit of lower costs might not seem much in any given year, over time the power of compounding makes a big difference to your eventual return.

The second is that most fund managers find it difficult to out-perform the market consistently year after year and that in aggregate the winners must be offset by the losers. In other words, active investment is a zero-sum game.

The counter argument from active investors is that the market can be beaten, if not all the time then consistently enough to make the effort worthwhile. This is principally because financial markets are not efficient. At any time most shares are either under- or over-priced and a skilful and experienced investor can spot these anomalies often enough to beat the market and to justify the higher costs involved.

Successful investors are not always right but they are right more than they are wrong because they stack the odds in their favour. They do this by picking companies with the soundest balance sheets or those with the most appealing valuations or the highest barriers to entry or the most efficient operations. In all sorts of ways, they make it more likely that they will pick winners and avoid losers.

Despite this, many studies over the years have seemed to make the case for passive investing. They show that relatively few active managers beat the market and, more to the point, they suggest that it is impossible on the basis of past performance to spot the winners of the future. Maybe this is true but, if so, it merely says that successful investing is hard, not that the search for successful investors is futile.

While the argument against active investment is often made, the case against passives is heard less often. There are, however, some uncomfortable truths about passive investing too. Here are three of them:

• When passive investing takes the form of tracking a market capitalisation-weighted index such as the S&P 500 or FTSE 100 (as it usually does) it leads to investors buying more of a share as its price rises because it accounts for a growing proportion of its index. An obvious example of this was Vodafone at the height of the dot.com boom or, more recently, RBS just before the credit crunch. Investors end up buying shares precisely when common sense tells them they should be reducing their exposure.
• By the same token, smaller and mid-cap stocks are de-emphasised by a passive approach despite the fact that these less well-known companies are probably less-effectively researched and so more likely to be mis-priced by the market. It is impossible for a passive investor to take a meaningful position in a small, under-valued share. This is a particular handicap during a period of market turmoil such as we experienced in the second half of 2008. As the chart below shows, smaller companies have outperformed significantly since December 2008 but most passive investors would not have been able to benefit from this.

• By definition, an index-tracking fund is obliged to buy every stock in the index it follows. It will buy the good, the bad and the ugly – a disastrous approach during a period when a particular sector or industry falls out of favour such as during the financial crisis last year. As an active investor you might have chosen to steer well clear of the banks in the eye of the storm or you might, on the contrary, have trawled for value in the sector when you thought the crisis was over. What you would have certainly not chosen to do was to own all the banks in the FTSE 100 because you had no choice.

The argument over active and passive investing isn’t going away soon. Indeed the argument seems to get more complicated as the debate turns to the merits of hybrid portfolio approaches such as a passive core with more active satellite funds or, conversely, an actively managed core with passive satellites in more exotic markets. We’re no closer to a conclusion than we were 35 years ago but anyone hoping that passive investing offers an easy solution is likely to be disappointed.