07 May Investing – Active vs. Passive (Part 3)
Recently we have observed an increase in the temperature of the debate about passive and active investment strategies. In a speech by the CIO of the Future Fund (5/5/17), Dr. Raphael Arndt, talks about the ‘new reality’ for active management and how we are “in an environment where sophisticated investors are no longer willing to pay active management fees for beta returns”. As humble as our opinion may be, we whole-heartedly agree.
We are aware there are active managers who can pull this off and a great many who cannot. Hence the assertion by the passive supporters that ‘on average, active managers cannot beat the index’. Identifying which is which is extremely difficult. So much so, we decided some time ago that it is our basic investment philosophy that matters, and identifying fund managers that align with this philosophy is the key. This alignment ensures we are pursuing our key mandate – helping clients achieve their financial objectives. These objectives are rarely as simple as generating the highest return over a given period, for a given level of risk. However it is defined, people just want to know if they will have enough.
Paul Keating (channelling former NSW Premier, Jack Lang), once said “in the race of life, always back self-interest. At least you know it’s trying”. When assessing the merits of the arguments between passive and active management, consider the underlying motivation of the author. A recent article by an active manager called passive management ‘lobotomised’. Not only is this churlish, but the manager was, ‘talking his own book’. His base argument, that any strategy has its ‘time in the sun’ and become victim of its own success is reasonable, but it works both ways. The article quoted the performance of one Hedge Fund Strategy, that has outperformed Warren Buffet, since 1987. But it ignores the bet Buffett made 9 years ago, where he challenged anyone to pick 5 hedge fund strategies that would out-perform the S&P 500 over 10 years. With one year to go, the only people to take him up on the bet, Protegé Partners LLC, have all but conceded.
Markets are adaptive. A preponderance of active management can effectively arbitrage away its own alpha. Similarly, the growth of passive strategies can provide increasing opportunities for active managers.
Human psychology is such that we will tend to herd towards what we perceive as better value. This perception will generally follow a period of superior performance, be it a winning share or a winning investment strategy. However, we will tend to overweight the potential of the company, or the investment strategy and stick with it longer than should be reasonable.
We believe there is a right investment strategy for each portfolio, each client. This can be active, passive or some combination of both. In our opinion the keys to good portfolio management are:
- Be at once open minded and skeptical.
- Avoid ‘fashion’. Chasing the next best thing will deplete your most valuable resource – time.
- Know the difference between marketing and research.
- Understand that investment markets are dynamic, the fortunes of specific strategies will ebb and flow over time.
- Context. Always keep in mind what the portfolio is seeking to achieve.
Enjoy Federal Budget week. Don’t be surprised if we see a change to CGT thresholds – my long shot call.
David Graham CIMA® CFP® SSA™