Portfolio Construction Series - Part One
Active vs Passive Asset Management - An Introduction
by Colin Campbell - Managing Director
Definitions
One of the big megatrends over the past 20 years has been the sustained rise of Passive Management for the construction of investment portfolios and diminishing the traditional hold that Active Management has had.
A manager is deemed “active” if they have discretion (inside the fund’s rules and disclosed mandate) to buy and sell securities/assets. Active strategies usually rely on managers' research, insights and analytical skills to strive to outperform their chosen market….net of fees.
Passive investing strategies seek to replicate the performance of a chosen market index, usually via an Exchange Traded Fund (ETF) i.e. the ASX 200. If the market price of the index moves in any way, the price of the ETF instantaneously does the same.
Passive taking market share from Active.
The Australian ETF market grew 37% over the past year to $206.2bn. Now, not all 334 ETFs are passive, but the bulk are.
This strong trend in the ETFs taking market share is for several reasons.
Fees. Typically, lower than active.
Consistent performance. Disappointing performance from some big brand Active managers (Magellan, Platinum, Pendal + others).
Transparency. When the client turns on the TV and see (for example) the ASX 200 up 1%, then they know their portfolio has had an identical gain.
Access. The Australian equity market represents a little over 2% of the global equity market, accessing ex Australian assets can be done simply and cheaply via ETFs.
Scalability. Active Fund managers usually have capacity constraints and ETFs generally don’t.
The headwinds facing Active Funds
Statistical proof of the performance gap of Passive over Active comes by way of a Standard and Poors publication which measures the persistence of performance of active managers, over time. This is known as the SPIVA index (S&P Passive vs Active index). This analyses whether managers have beaten an investment index over time. As the graph below illustrates, the question of whether active fund managers outperform their benchmarks is more a matter of luck than skill, as demonstrated by their performance consistency over time. - “today’s rooster is often tomorrow’s feather duster”.
Why the Criticism of Passive Investing?
With the Passive wave of investing outweighing Active, some market commentators have put forward the proposition that the risks to markets have increased. Some key arguments are;
1. Market Risk. The sheer amount of capital that continues to pour into passive strategies could leave the market prone to unstable violent swings and potential crashes.
2. Concentration Risk. Creates a bias to large cap stocks (Mag 7) over small.
3. Liquidity Risk. Passive investors are “free riders” where all the hard work in providing liquidity and price discovery (where a stock will trade) is done by active investors.
4. Potential for lower returns. Passive investing is portrayed as the “dumb” money in markets and Active investment is the “smart” money. Passive investors do not analyze companies the way value investors do, but merely own stocks that have made it into the indices.
5. Control. No control over which stocks investors own.
Finally
GMO wrote in their recent paper on passive vs active:
“It is important to keep in mind that whatever effects the rise of passive investing has had, it doesn’t change the way that stock investors make money in the long term. The primary drivers of long-term returns in the stock market are the future cash flows of the underlying companies and the prices that investors pay for those cash flows. Passive has unquestionably changed the landscape of investing. But it hasn’t changed the math of investing, and at the end of the day it is the math that matters most.”
Disclaimer: This information is provided by Carnbrea & Co Limited ABN 33 004 739 655, Australian Financial Services Licence No. 233763. Any advice included in this document is general in nature and does not take into account your objectives, financial situation or needs. Before acting on the advice, you should consider whether it is appropriate to you. If a product we recommend has a Product Disclosure Statement (PDS) or a Prospectus, you should read it before making a decision. Past performance is not a reliable indicator of future performance. Derivatives are leveraged products which means gains and losses are magnified and you may lose substantially more than your initial investment. We do not endorse any information from research providers that we provide to you, unless we specifically say so.
Reference articles: https://www.spglobal.com/spdji/en/spiva/article/spiva-australia/ Australia Persistence Scorecard: Year-End 2023 - SPIVA | S&P Dow Jones Indices (spglobal.com) Global-X-Australian-ETF-Market-Scoop-June-2024.pdf (globalxetfs.com.au https://www.gmo.com/globalassets/articles/quarterly-letter/2024/gmo-quarterly-letter_2q-2024.pdf Why Michael Green Is Known as the Cassandra of Passive Investing