Passive Investors – What is your thesis?

The debate as to the merits of investing passively or actively rages on. And over recent months, we have observed a sharp acceleration of flows into passive equity strategies – largely at the expense of active equity strategies.

Source: Citi 

We have argued in the past that, in a lower-returning world, “locking in” the market return with a passive index strategy may be doing investors a disservice. To understand this argument, simply flip it on its head: if you believed equity returns would be 20-30 percent every year, then passive strategies would be all you need. In a world that delivers you, say, five percent annual average equity returns, then every +3-5 percent of outperformance that a high-quality active manager can deliver, after fees, is a much larger share of the total return and therefore much more valuable to the investor.

But putting this argument aside, we are genuinely trying to understand the rationale for using passive equity strategies. Here’s what we can come up with:

1. The fees are typically lower than for an actively managed strategy – this means that if the active manager cannot generate enough outperformance than the fees they charge then the investor is worse off.
2. An index fund will guarantee the market return whereas an active strategy could underperform the market – this again relates to the risk that the active manager is not capable of sustainably outperforming the market.
3. As more investors pile into passive funds, this pushes the market up – yes we have actually heard this argument. This is akin to saying that I don’t care what price I pay for an asset because I believe there will always be someone else after me with the same attitude. But this, of course, suffers from the fallacy of composition. That is, it cannot work when everyone believes this.

The first two reasons above are valid (the third is asinine, in our view). And they are really two sides of the same coin which is “manager risk”. While there are high-quality managers out there who are going to consistently outperform the market, how can an investor identify them ahead of time? This is no trivial task, for sure. Investors need to assess a manager’s philosophy, investment process and discipline with which that process is followed.

But as the flow of funds into passive index strategies accelerates – these funds are, by definition, buying assets with complete disregard for the price they are paying. And, if an asset is overvalued, chances are the passive equity fund will overweight its allocation to this asset.

In this world, we believe investors who spend the time and effort to identify high-quality active managers will be rewarded handsomely over the long term. Remember the starting point today is very different from where it was 30 years ago. Investors 30 years ago would have done just fine holding onto a passive equity index fund. Investors who hold passive equity index funds for the next 30 years probably won’t be so fortunate.

Andrew Macken is a Portfolio Manager with Montgomery Global Investment Management. To learn more about Montaka, please call +612 7202 0100.