Thoughts On The Active vs. Passive Debate

By David Bassanese | More Articles by David Bassanese

With the strong growth in index funds and exchange traded funds (ETFs) in the Australian marketplace in recent years, debate is again swirling on the benefits of active vs. passive investment management.

Some commentators have suggested that index-oriented investments are merely for “dumb” investors, who have no real skills in picking mispriced securities likely to outperm the market.  If this were to be true, it would follow that these investors are leaving money on the table as by either investing in the development of these skills – or hiring talented active managers – they could produce better returns. It has been suggested that over the very long run, “sensible investing” in “quality” stocks “will beat an index”. How true is this? (spoiler alert: the evidence suggests this is not true!). This note offers some perspectives.

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The evidence suggests most active managers can’t and don’t outperform the index

Fortunately for participants in the perennial active/passive debate, whether active managers can outperform a market-cap weighted index is ultimately an empirical question.  On this score, the evidence seems overwhelmingly in favour of passive investment – both in Australia and overseas. 

According to the latest SPIVA Australia Scorecard by S&P Dow Jones Indices, charted above, for example, a full ~78% of active Australian general equity managers underperformed the S&P/ASX 200 Index over the five years ending December 2014.  The performance of local international equity managers, Australian fixed-income managers, and listed property managers was in fact somewhat worse. Over the latest 3-year period, the scorecard was slightly better for Australian equities active managers, although 6 in 10 managers still underperformed.

Even if active managers were able to consistently outperform the market, moreover, their degree of outperformance would need to exceed their management fees to beat some of the very low cost ETFs and index funds available.  As but one example, a fund that charged a 1% p.a. management fee plus a 10% outperformance fee would need to generate a return of 11.5% p.a. to offer the same return to an investor in an index product that rose by 10% in the year and charged a management fee of 0.15% p.a. If the index fund’s gross return rose to 20% for the year, the active fund would need to generate a 22.6% annual return – or a before fee outperformance of 2.6%.  Overall, during periods of strong index returns, active managers have to outperform by even more to justify higher fees.

Of those active managers that do outperform over a certain period, such outperformance is unlikely to persist

Of course, the above evidence suggests that some active managers can outperform the market.  The only challenge investors face, therefore, is in identifying these superior managers.  The problem, however, is that actually picking active managers that consistently outperform is not as easy as it seems.  As the old truism goes, past performance is not a great indicator of future performance.
The chart below, for example, is based on research on Australian active equity managers from Mercer Consulting which tracked the performance of investment managers across two three-year investment periods.  The question is: how many of the funds that performed well in the first period also performed well in the second period? In other words, how persistent was outperformance?

As seen in the chart, it turns out that only 24% of the 29 funds identified by Mercer as enjoying top quartile investment performance in the three-years to September 2010, were also able to produce top-quartile performance in the three-years to September 2013.  In fact, statistically speaking, the most likely scenario (31%) is for a top quartile performer in the first period to end up becoming a fourth quartile performer in the second period!  Meanwhile, almost one in five of these top performing funds ceased operation (or were merged/taken-over) in the second three-year investment period.

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Indeed, according to the Mercer Survey, of the 32 funds with top quartile performance in the three-years to September 2013 (among 126 funds covered), 16 – or 50% – of these funds were new to the market.

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As they dominate the market, it’s hard for all active managers to outperform all of the time

Due to the fact that institutional money – which is still predominantly active in nature – tends to dominate ownership and therefore trading in the Australian equity market, it stands to reason that not all managers (who effectively “are” the market) can outperform the market all of the time.  This is because for every ‘winning’ trade, there will equally be a ‘loser’ on the other side.

As seen in the chart below, of the $1.6 trillion worth of “listed and other” equities in Australia as at end-December 2014, a whopping $1.4 trillion – or 83% – was owned either by domestic insitutional investors, or foreign owers (which are also largely institutional).  Households directly owned only around $200 billion, or 13%.   With active managers owning around 80% of the market, their collective attempt to beat the market is akin to a zero-sum game.

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Exchange Traded Funds can do more than just track market cap-weighted indices

It’s also important to know that, due to the development and continued innovation in indexation – there are now a number of indices which recognise the limitations of traditional market-cap weighted indices, including some offered by my firm, BetaShares. These ‘smart beta’ indices, such as, for example, fundamental weighted indices, combine the benefits of index funds (i.e. low  cost, transparent, diversified, rules based) along with the potential to outperform the market-cap benchmark.

We’re a long way from passive investment distorting the market

There has been some conjecture that the continued growth of index investing and ETFs may contribute to potential market distortions. Truth is, we’re a long way away from that. According to Morningstar Research estimates, passive investment strategies have accounted for around 8% of the Australian managed funds industry in recent years – at these levels its unlikely rebalances in such products will be a major influence on market pricing.  With only ~$18 billion funds under management, moreover, ETPs account for only ~0.7% of the $2.4 trillion managed funds industry as at March 2015.

That said, even in the United States – where passive investment is estimated to account for a much larger 24% of funds under management in 2013 – it still seems evident that active managers have a hard time beating the market.  According to S&P’s latest survey, for example, 88% of large-cap US managers failed to beat the S&P 500 index in the 5-years to end-2014.

With all that said, there is no doubt that there do exist a select number of active managers who have a strong track record of persistent outperformance. At BetaShares, we firmly believe that active management has a role to play in investors’ portfolios, and often find ourselves discussing how ETFs can be used in combination with high quality active managers. However, when considering the active vs. passive debate, we believe it’s important to be armed with the empirical facts.


David is Chief Economist with BetaShares, and an Economic Advisor to the National Institute for Economic and Industry Research (NIEIR). His has held former roles as senior commentator with The Australian Financial Review, Macquarie Bank interest rate strategist and Federal Treasury economist.


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About David Bassanese

David Bassanese is one of Australia's leading economic and financial market analysts. His is Chief Economist with BetaShares and former market columnist with The Australian Financial Review. He has previously worked in economist roles at the Federal Treasury, OECD and Macquarie Bank.

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