When buying a passive fund, investors choose to be content with the market’s returns; those who want more must resort to active managers for a chance that their stock-picking will be better than everyone else’s.
As markets become increasingly efficient, the number of people who can consistently beat them is becoming smaller – which some experts use as an argument in favour of passive investing.
Others take the opposite view and argue that investors shouldn’t give up on trying to find good active managers just because it is difficult.
To show just how hard it is, over the past five years, 78.7% of US large-cap funds underperformed the S&P 500 and 90% of European equity funds lagged behind the S&P Europe 350 index, according to SPIVA data.
Below, Trustnet collated opinions on how tough it actually is for active managers to outperform and what investors should take into account when constructing portfolios.
Team ‘slim chances’
It is “very hard” for stock-pickers to outperform large, efficient markets, according to Alastair Laing, co-manager of Capital Gearing.
For this reason, he does not pick stocks himself and instead tries to generate alpha from investment trusts by buying their shares at a discount to their net asset value (NAV).
“We don't try and work out whether Shell, BP or Exxon, or Microsoft or Google, is a better investment. There's a lot of research suggesting that in these quite efficient markets, it's very hard to out-stock-pick someone else, who is also very intelligent and has access to a lot of information,” he said.
“What you certainly don't want to be doing is paying very high levels of fees in order for someone to try and beat an index such as the S&P 500. Very few people are going to outperform the S&P 500 by their stock-picking ability.”
His suggestion is to have passives as core building blocks and surround them with satellite holdings in other areas where active managers can do more, such as small caps and specialist investment styles.
Jonathan Moyes, head of investment research at Wealth Club, agreed with Laing that the bar to outperform through stock selection within highly efficient markets, especially within large and mega caps, is very high. Therefore, he uses passive strategies as the low-cost core of portfolios.
Typically for the Wealth Club, around 40-45% of assets under management are held in passive strategies, paired with specialist active managers and listed investment companies.
Moyes looks for specialist active managers who are “well-resourced and well-rehearsed” and prefers investment teams with equity participation in the business.
“For trusts, we go one step further and look to own strategies that cannot be replicated by trackers or daily dealt open-ended funds, such as private equity (HgCapital Trust) and private infrastructure (Brookfield Infrastructure Partners),” he explained.
Team ‘some chances’
Robert Fullerton, senior research analyst at Hawksmoor Investment Management, “completely disagreed” that managers can’t out stock-pick each other, but whether they can sustain outperformance for a long time “is another question”.
“It depends on time horizons. The way we approach this is by trying to understand what managers do, rather than simply ranking them,” he said. “If one manager is outperforming over one, three and five years and another is outperforming over 10 years, which one is winning? It will depend.”
He admitted, however, that it is hard to navigate large, efficient markets and that in certain sectors, trackers rank quite highly against active funds. But the idea that the average manager underperforms the market mostly means that the average manager isn’t very good, he said. And even though really good fund managers are few and far between, that “doesn’t mean you shouldn’t try” to find them.
Discretionary managers such as Hawksmoor are under a certain amount of pressure to keep costs low, which might steer them towards passives. But index tracking has drawbacks too, Fullerton argued. “In a tracker, you are likely to own a lot of companies not earning their cost of capital and carry all this dead weight – admittedly for a lower fee – when a relatively small number of opportunities do exist outside this for (good) active managers.”
James Klempster, deputy head of the Liontrust multi-asset team, believes there still are enough market inefficiencies and mispricing for active managers to exploit. Their outperformance may well be “lumpy” but it should smooth out over time, he added.
"Where we use active managers, we aim to blend them to ensure we provide a combination of differentiated returns streams within an asset class,” he said.
“In deciding whether to use a passive vehicle, we consider whether it is suitable for the market in question, analysing liquidity and depth of markets.”
In the Liontrust Blended fund and Portfolio ranges, the team invests with a combination of active and passive managers, weighing up each equity market independently, Klempster explained.
“It involves analysing long-term data using metrics such as cross-sectional volatility, the percentage of stocks that have historically beaten the index and the level of concentration in the index. This provides a guide to historical success, although clearly these market dynamics will shift over time.”
Currently, five of the top 10 holdings in the £383m Liontrust MA Blended Intermediate fund are passive vehicles, including a corporate bond fund and equity strategies in the US, emerging markets, Asia Pacific ex-Japan and the UK; whereas active managers cover areas such as high-yield bonds and US value equities, as well as adding some more nuanced positions to the portfolio’s corporate bond exposure.