Active or passive management? The question is very popular in the world of asset management. He divides the crowds, with true partisans of both factions. The growing success of ETFs, passive instruments par excellence, is adding fuel to the fire. Instead of fueling the fire, I will try to contribute sensibly and with intellectual honesty to the age-old "active vs. passive" debate, providing well documented numbers and facts. A little help to orient yourself in investment choices.
I would say that, roughly speaking, these are the main facts.
WHAT ACTIVE (AND PASSIVE) MANAGEMENT MEAN
The majority of mutual funds and sicavs have a benchmark, i.e. a reference financial index made up of securities, which represents the reference market. Passive products like ETFs simply try to replicate that. Active products, on the other hand, seek to outperform the benchmark: the active manager intends to "beat the market", obtaining an "extra return". Which would then be the so-called "alpha" of management. It should be noted that ETFs have negative alpha on average, due to the commissions and trading costs incurred for replication: for equity ETFs, this is on average -0,26% per year (based on Morningstar data).
But let's get back to active funds. An active manager aiming to beat an index has only one way to add value and create alpha: by deviating from the benchmark. At any moment, he can do it essentially in two ways:
1) choosing different stocks – and this is stock-picking;
2) exposing themselves differently to geopolitical areas, sectors, and other market factors (eg Value stocks, or Small Caps, and so on) – this is asset allocation.
To quantify how active a product is I would argue that there are two sovereign metrics:
1) the Active Share (AS) – it is (intuitively – maybe in the next eon I'll write a post on this indicator) the percentage of the fund's investments that differ from those of the benchmark index;
2) Tracking Error Volatility (TEV) – i.e. the volatility of the difference between the fund's return and that of the benchmark; in essence, the TEV measures the fund's volatility not explained by market movements, but by active management choices.
Based on the entity of AS and TEV, inspired by the work of Antti Petajisto of New York University, we can divide the funds into various categories, heuristically represented in the following graph:
– TEV and AS both very low – here we are talking about openly passive products, such as ETFs;
– medium AS and high TEV – it means that they do not differ so much in the choice of securities, but more in the asset allocation;
– High AS and low TEV – stock pickers who reduce risk through good diversification;
– VTE and AS both very high – symptom of active management “thrust” in all directions;
– medium/low TEV and low AS – active ETFs (yeah, there aren't many at the moment, but they exist);
– TEV and low AS – practitioners of the highly questionable sport of closet indexing, i.e. managers who declare themselves active (and charge commensurate commissions) but who are essentially passive.
PERFORMANCE
Part of my job is to regularly sift through academic and industry research on mutual fund performance and risk, so I can give you a decent digest. The data tells us that the majority of active mutual funds do worse than the market. However, the panorama is not homogeneous; see the case of Italian equity funds, decidedly better than the average. Also, the longer the time frame over which fund performance is analysed, the less active funds are able to beat the market. In short, the quality of active management on average is not durable.
Then there is the work of Barras, Scaillet and Wermers, published in the authoritative Journal of Finance: it shows that 75% of funds have zero alpha, about 20% even have negative alpha, and only 5% have alpha positive. Similar results are found in the work of Nitzsche, Cuthbertsonn and O'Sullivan: about 2-5% of the best equity funds in the UK and US are genuinely better than their benchmarks, while 20-40% are really bad, with significantly negative alpha . These, however, are average results of the asset management industry. I'll say it again: average results. That is, relative to the aggregate of mutual funds (which number several thousand in Italy alone and around 80.000 worldwide). If you imagine that within this magnum sea of investments there are pearls, well, you imagine right. Just to give you an idea, look at the following graph, relating to the Italian market: the "space of excellence" is large, and there are management teams capable of producing very good results.
So let's try to investigate.
STOCK PICKING AND RISK DIVERSIFICATION
The chart below is a summary of a recent study by Antti Petajisto of New York University, which ranked US equity mutual funds using AS and TEV, and then analyzed their performance. Well, funds that carry out authentic stock picking (that is, the prudent choice of a few stocks), while maintaining a good diversification of risks, on average perform significantly better than the benchmark: we are talking about 1,26% on average per year. It's not little. The other types of management, in aggregate, do not add value. Funds that define themselves as active funds stand out for their negativity and disgust, and usually charge high commissions, but in practice they are passive: these are funds that practice closet indexing. According to a study by ESMA, the European financial market supervisory authority, between 5% and 15% of mutual funds in the EU belong to this scoundrel category. According to Morningstar, among "active" European equity funds domiciled in Italy, two out of three actually practice closet indexing and, in fact, do not deserve the commissions they charge to clients.
But back to the stock pickers: picking the right stocks is a tough job, given that the majority of stocks, taken individually, have dismal returns. This is the result of the research conducted by Hendrik Bessembinder with data from 1925 to today, relating to the largest and most representative stock market in the world - the US Stock Exchange. Out of almost 26 shares, only 42,1% managed to produce a return higher than that of an almost risk-free bond (1-month Treasury Bills). The other equities produced a lower and often negative return. It emerges that the US Stock Exchange from 1926 to today has created wealth with 4% (four, yes) of the shares. The message is: stock picking is tough, but professionals who can do it extract value from the market. The problem is to distinguish skill from mere luck ex-ante, and not a posteriori.
PERSISTENCE OF PERFORMANCE
To select really good managers, the first thing that comes to mind is to identify those with the best performances (best if adjusted for risk, perhaps with the Sharpe Ratio).
The point is: but then, are those managers still good? That is: is alpha persistent?
Data on equity and bond funds from S&P Dow Jones shows that, among those who show positive alpha, after one year, less than 20% of managers are able to continue to generate value. After three years, the persistence of alpha asymptotically and sadly approaches zero, as is evident from the graph below.
FEES
Active management requires more analysis and research, therefore it costs more than passive management. But how much more?
The answer is in the following graph (data from Mediobanca and Morningstar). On average, the annual fee cost (TER) of active mutual funds is about four times that of the classic passive instruments, the ETF. However, the latter are also burdened by the bid-ask (or bid-ask) spread – on average by a few tens of basis points – an additional cost linked to negotiation, which is instead absent in the funds. Again, these are average data: Smart Beta ETFs cost on average a few tens of basis points more. Conversely, there are active mutual funds sold directly by management companies, even online, with costs often close to those of ETFs.
It should be kept in mind that, with the prevailing business model of the asset management industry (which will change with the entry into force of the MIFID 2 regulation in 2018), the commissions of the majority of mutual funds sold in Italy go to remunerate the activity of mere sale, and not that of management – and we have talked about this “little problem” abundantly.
However, academic research highlights a rather extraordinary fact: the asset management industry is perhaps the only one in which cost (ie commissions) is inversely correlated to quality. This historic result, published in the Journal of Finance by Javier Gil-Bazo and Pablo Ruiz-Verdú, simply means that funds with lower fees (TERs) often outperform those with higher fees. In short, the equation "the more it costs = the better it is" does not apply here. And this, considering how much impact costs have on the final result of an investment, is great news.
ZEN REFLECTION
I think there is some useful data on the plate so that you can form your own opinion.
But there is one more thing. An aspect that perhaps escapes the partisans of both fronts, both "passive" and "active". And that is that active and passive management are complementary like yin and yang. It's not a feel-good conclusion, it's pure logic supported by data.
– Without passive management there would be too many active managers and alpha would be even more evanescent and elusive. Indeed, the problem with alpha is not that the managers are minus habens, but, paradoxically, that there are too many good people, so that the best investment opportunities vanish immediately (such as concert tickets on the evil TicketOne or planes on offer online). The data also show that in countries with more passive products the quality of active management is better.
– If there were no active managers, the market would be more illiquid, crystallized in financial indices, and companies (or Governments, for government bonds) that are doing badly would remain "hidden", since no one would punish them with the sale of their titles. Everyone would limit themselves to uncritically buying shares and bonds in the proportions defined by the indices. Natural selection would be missing, which is fundamental. (The corollary is: if the proportion of passive managers increases, the opportunities for active managers increase).
Therefore, beyond the choices of individual investors, it is good to keep in mind that at the level of the financial ecosystem, the simultaneous presence of passive and active management is healthy.
Source: AdviseOnly
