At Consilium, we believe a growing body of evidence has moved us past the traditional active vs. passive debate. The best evidence comes from the US where the research has been collected and mostly aptly documented. The traditional debate contrasts an index fund, representing the passive camp, and an active equity or hedge fund, representing the active camp.
A widely publicised wager between Warren Buffett and a hedge fund manager called Protégé Partners illustrates the point. Buffett bet that that the Vanguard S&P 500 (a passive index type fund) would beat a selected group of hedge funds over a 10 year time horizon. So far the Vanguard fund is up 43.8%, compared with the hedge fund’s gain of just 12.5% since the bet was made.
Buffett’s backing of the S&P 500 was primarily an argument about the significance of cost minimisation not philosophy. In his 2013 Berkshire Hathaway letter to shareholders, Buffett said he had instructed his estate to put 90% of his funds into the Vanguard S&P 500 and 10% in cash. Here’s his rationale:
“Both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal…”
This observation, from one of the greatest stock pickers in history, suggests that one does not necessarily need to agree with a passive investment philosophy to observe the weight of the evidence. The evidence shows, overwhelmingly, that investors are not rewarded by the high costs of active investment management.
When Russell Kinnel, director of research at Morningstar, attempted to identify the number one predictor of performance for investment managers, his findings also made a compelling argument in favour of low cost investing.
“If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds… Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.” Russell Kinnel, Morningstar FundInvestor, vol. 18, no. 12 (August), p 1 – 3.
The second part of the debate focuses on persistence in performance. Every study of the persistence of active managers to deliver outperformance (and there have been plenty) shows that, once you control for risk, there is no statistically meaningful performance persistence.
To illustrate simply, Vanguard conducted a study in which they ranked all US equity funds in terms of excess return versus their stated benchmark over the five years ending 2008. They divided the funds into quintiles, separating out the top 20% of funds. They then tracked the performance of those top 20% of funds over the following five years through December 2013 to check for persistence. If the top quintile funds displayed any meaningful performance persistence, we would expect a significant majority to remain in the top 20% five years later. A random outcome would result in about 20% of the funds dispersed evenly across the five quintiles.
The results were close to random. Only 12% of funds repeated a top quintile performance, while 28% moved to the bottom quintile.
If costs really matter and performance persistence by active managers cannot be counted on, is there a reliable way outperform markets?
This is where we depart from the traditional passive vs. active discussion. Considerable research shows that low cost shares (based on a combination of fundamental ratios), small company shares and profitable company shares exhibit higher returns than the market over long periods of time. The figure below compares long term value, small cap, growth and total market indices for various markets.
Both value and small cap segments of the market outperform total market and growth. The implications of this are that not every share has the same expected return. This is probably because shares incorporate unique systematic risks, for which prices and market capitalisation are merely a proxy. And there are other proxies beyond just these two. The question is how to invest in shares with a higher expected return. Do we pay a manager to pick what he believes are the best of the bunch? Two problems arise with this approach – the manager’s fee (evidence shows this is not money well spent) and also that we lose some of the virtually costless benefits of diversification.
Passive investors can defeat both of these problems. They can use very low cost and highly diversified funds to access these sources of higher expected returns in a way that adds long term value over broad market benchmarks and peers.
In everything we do, the core of the argument is always evidence. We want to see evidence – evidence that has some statistical relevance; evidence that is persistent across time periods, pervasive across markets and has a sound economic rationale to it. We want to see evidence that ideas don’t work merely in theory or on paper, but can produce results after considering the costs of management, transactions and taxes. The problem with active management as it’s traditionally described is that the evidence simply doesn’t stack up.
As for the debate about active vs. passive… If it’s purely an argument based on conjecture and opinion, it will probably never end. However, if evidence counts for anything, we think this debate was settled a long time ago.
