Why should I pay for active fund management when passive is so much cheaper?
We believe the market is inefficient – if we didn’t believe this there would be no need for active fund management. As active investors, we believe we can exploit the market’s inefficiencies to add value by outperforming the market (and, therefore, passive funds which track the market) in the long run.
The main reason the active versus passive debate gets air time is because many active fund managers do not add value – they destroy value by underperforming. Market performance is, in essence, an average of all outperforming funds and all underperforming funds.
The main advantage of a passive strategy is its lower fee structure which allows investors to cheaply avoid the risk of choosing the wrong active fund manager. We are working hard to keep our costs low but we cannot possibly compete with the ultra-low fee structures of passive funds.
But proven active fund management comes into its own in periods when the market environment as a whole is more challenging. In periods when the market is moving sideways or in decline, an appropriate active fund management strategy can continue to deliver positive returns.
Actively managed funds can buck the trend of a falling market, whereas passive funds are locked into the downward trend. The post-bubble experience of 2000-01 is a great example of this – the market was embarking on a protracted decline as the bubble deflated, but some fund managers, Neil Woodford included, were able to continue to deliver positive returns by avoiding the over-valued shares that were at the heart of the market’s slide and focusing their portfolios towards the under-valued parts of the market that had been shunned while the bubble was inflating. This was a period when talented active fund managers with a disciplined approach and a sensible, valuation-focused strategy, were able to really demonstrate the value they can add.
The past five years have told a very different story, however. The market has been difficult to beat – in other words, it has been much harder for active fund managers to add value through outperformance even though many have delivered attractively positive returns.
But rather than question whether paying more for an active fund manager is sensible or not, we believe it is more sensible to try to understand why the market has been difficult to beat over the last five years, and whether these reasons will continue to influence markets over the next five years and more.
In our view, the primary market driver over the last five years has been the extraordinary monetary policy that has been in place throughout this period in the form of Quantitative Easing (QE). QE was designed to lift asset prices and, in this regard, it has worked. But it has not been discriminate – the tide of QE has lifted all ships. All shares have benefited, not equally, but correlations between stocks have been much lower over the last five years than is usually the case. It should not be a surprise, therefore, that this has been a difficult period for active fund managers, particularly those with a fundamental, long term approach, to outperform an artificially buoyant market.
The question is, therefore, is QE going to have the same effect over the next five years? Very unlikely, in our view. It is already being withdrawn in the US, primarily because central bankers have become considerably more concerned about the unintended consequences of the policy, including the risk of inflating new asset price bubbles. The tide of QE is now going out again and, as Warren Buffett once said, “you only find out who is swimming naked when the tide goes out.”
To conclude, there are some periods in equity markets when passive strategies perform well and others when active fund managers thrive. Looking through these cycles, successful active fund managers have proven they can add value by focusing on and delivering attractive long term positive returns, particularly in more challenging market conditions. We believe the market is transitioning from a period which has been benign for passive strategies, to one in which active fund managers with a sensible, proven investment approach and an appropriate strategy, can add significant value.