Now here\’s a surprising column

A man arguing in favour of actively managed investment funds instead of low cost (and even no load) passive trackers.

One thing that has long puzzled me has been the preference of many investors for index-tracking funds or passive ETFs – both designed to simply match the performance of an index like the FTSE 100 – over traditional funds where a professional investor is employed to try to beat the market by picking the best stocks.

Why is this so surprising? Well, because both theory and practice say that passive trackers are indeed the way to go. The costs of active management are greater than the extra (even when there is some extra) returns. And theory backs it up: the efficient markets hypothesis says that this should be so (note to people who rant and rave about the EMH being obviously wrong. That passive trackers are indeed better investments than active funds is strong evidence in favour of the EMH).

So it\’s a bit surprising to see a financial pages columnist arguing the other way.

Tom Stevenson is an investment director at Fidelity Worldwide Investment.

Extremely surprising, eh?

20 thoughts on “Now here\’s a surprising column”

  1. The value of active fund managers is that their hard work and search for information, means that the market behaves more efficiently. So this makes index investing more efficient that it would otherwise be.

    Tim adds: Excellent. So we’ve a public good then. Non rivalrous and non excludable. And when one of those exists the logical thing #for any individual to be is a free rider.

    That still points to investing in index funds as the logical position for the individual investor.

  2. Thing is, actively managed funds must on average, over time, tend to a zero-sum game (minus the management costs) with respect to the market all on its own. For sure, some fund managers will get more information sooner and make better decisions, others will have to raise their game or lose out relative to those, and when they do they cancel out the advantage of the “good” guys. Either way – all top-notch rational investment managers or a spread thereof they only have the same few thousand shares to choose from.

    If you are putting your money into a company that you are not “actively managing” yourself (i.e. are privy to information the wider market doesn’t have – which once you get to listed companies can put you in hot water for acting on) this always has to be something of a gamble.

  3. For investing in managed funds to make sense you need to believe three things:
    1) That managers who are capable of systematically beating the market exist. ( i.e. that the EMH is false)
    2) That you can reliably identify these managers ahead of time.
    3) That these managers will willingly give up some of their extra returns to you, returns which they and they alone have produced.
    I’d argue that all three of those statements are false, but in any case, you can disbelieve the EMH and still think that index funds are the best investment.

  4. Is it not a problem that if everyone invested in index linked trackers, and no-one used a managed fund or self managed, stock prices would become meaningless.
    Of course, if that happened I guess returns on index investments would plummet, and managed fund would become more profitable.
    So maybe a balance is achieved?

  5. I predict that all returns from managed funds are normally distributed about the mean but that over a longer period of time the results are skewed positive because there is a lower bound (you run out of money) but no upper bound. And there are enough funds that a few of them end up outperforming several years in a row. But that’s stochastic. If the industry as a whole works no better than a matched and entirely random set of investments would, that would settle it. Wouldn’t be hard to take fund returns over the last 10 years and get a computer to run 100,000 comparable investment strategies at random using historical share price data. A maths postgrad could do this in a weekend.

  6. Rant rant rant
    Passive trackers – BEFORE expenses and tax – outperform active funds – AFTER expenses.
    The best data that I have seen show that passive funds AFTER expenses perform worse than active funds after expenses.

    What matters is performance after expenses and tax, so active funds tend to be weighted towards “growth” stocks which over the long term provide better after-tax returns than “income” stocks – this of course pushes up the price of “growth” stocks so that they produce lower pre-tax returns than “income” stocks. Hence the tracker fund salesmen can claim that the average active fund underperforms the index. There are a number of costs involved in fund administration which make a difference between pure investment performance and net investor return so Virgin guarantee that investors in their funds will underperform the index by 1% per annum. The average actively-managed fund does better than that even at the pre-tax level.

  7. there are managers and investors who consistently outperform the market – Warren Buffett has done it for a long long time, for example. Some trackers actually do not track their index very well. If you had invested in Berkshire Hathaway, you would have done much better than by investing in a tracker. Some managers do outperform the market for considerable periods of time, although the tendency for the mass is to converge to the mean. It just shows how meaningless averages can be when you want to make a decision.

  8. Warren Buffett might be very good at what he does. Or he might simply be the most extreme stochastic outlier you would expect given the few million people who’ve made a serious effort to make serious money.

    Or maybe he’s a bit of both.

  9. John77: “The best data that I have seen show that passive funds AFTER expenses perform worse than active funds after expenses.”

    Do you remember where you saw this? I haven’t spent ages searching, but I haven’t yet been able to find anything that looks at both after expenses in a market as established as the FTSE 100.

  10. Good to see you having a go at “capitalist” rent seekers.

    Following Pat’s point, do a proportion of funds need to be actively managed before either a) the market stops being efficient or b) managers of companies start looting them even more than currently?

  11. I think cheap passives are a good core investment. But I also think that it would be very strange if, in one area of endeavour, skill and human excellence didn’t exist. It may be that investors end up paying too much for this skill, and that investors pay for it even though the manager for their funds (see any insurance company or bank fund for more details) doesn’t have it, but it’s pretty hard to say that it doesn’t exist. And I was a director of a fund management business with active and passive funds.

  12. Isn’t this just a matter of timeframe? It’s perfectly possible to accept the precepts of the EMH and a long term reversion to the mean, while also accepting that the particular approach of an active fund manager may beat the index simply by being more appropriate (whether by luck or good management) to the market conditions ruling during a certain period of time.

    The trick then lies in identifying the fund manager and the time period. Which is where momentum investing comes in…

  13. Ken, thanks. I’ll read at my leisure.

    “Why the sweeping generalisations? Why not some markets that suit passives, some actives?”

    Aren’t we going round in circles? The average is always going to be near enough to the index, less costs. Even if active stands a chance, how do I know which active manager is going to benefit at the expense of the others? For active managers to “win” someone has to lose – who are the losers, if not other active funds?

    They might do something useful like reducing exposure to a big co in a small market, but that’s at the risk of underperforming if that co does well. But, say, Finnish investors worried about overexposure to Nokia could always have invested in a world index fund.

  14. Is Tim falling for the fallacy of averages?
    Of course, on average, the average performs averagely. But what does this tell us? Few aim to be average. We take a gamble on doing better than that, on beating the odds.

    Remember, the average horse does not win or, in most races, come in the first three. Nor does the average human runner. The average oil well drilling is dry. The average blog is read by hardly anyone. The average new restaurant closes in 18 months. The average new business lasts only 5 years (or whatever the current figure).

    So why bother to do any of these things. And most of all, never buy anything at an auction. If you win it means you are paying more than anyone else thought reasonable, let alone the average person. Much better to buy at a shop, car showroom or Amazon, where everyone pays the same price.

    Unless you rebel against the tyranny of the average.

  15. Outsider: it depends on how much of your time you’re willing to put into trying to be non-average in each sector of your life.

  16. @outsider, hence the difference between running, actively managing, your own business rather than paying someone to decide which of various businesses to put your money into, over which you then exercise no control at all.

    With an investment fund, pension scheme and whatever you don’t even get to vote your own shares, as you would if you owned them directly.

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