Active vs Passive Funds? Take a stand against mediocrity

Peter Elston insists whether active or passive, we should never accept average.

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The investment profession is one I have often said that I both love and loath. I love the company or country analysis; and the fact that it is clear from the numbers whether you have done better for your clients than your competitors. Conversely, I dislike the personality cults that grow around fund managers; the fact that poor performing funds and their managers stick around for longer than they should; and that all too often the regulators do not appear to be doing enough to protect small investors.

The inexorable rise of passive funds over the last three decades stands as testament to the fact that many investors, big and small, have become happy with average, as represented by the return of, say, the FTSE 100 index or the Bloomberg Barclays Global Aggregate bond index. The reason for this shift is that this average looks great in relation to the overall performance of actively managed funds.

I would argue that these headlines about the percentage of actively managed funds that underperform, say, the S&P500 or the OMX Stockholm 30 miss the point. Why? They imply that funds that perform in line with the index are doing well.

This must be wrong – an investor should not be satisfied with an active fund’s performance that is in line with the index when he could have got the same without any risk from a passive fund. A good active fund should be considered one that beats the index by some margin, compensating investors for the inherent risk of underperformance. Yet this is not how things are viewed.

Related: Should I invest in active or passive funds?

Another way to think about it is that an actively managed fund that performs in line with the index is one that beats the index but pays all the excess returns to itself in fees, once other costs such as custody have been deducted. The client gets nothing.

My rule of thumb is that I should be aiming for excess returns before costs that are around three times management fees. This allows for a decent chunk of the excess returns to accrue to the client. Aiming for anything less is, in my view, criminal.

Survival of the fittest

I can understand the move away from active towards passive, and that a passive approach makes sense for many. However, accepting the average offered by a passive fund, reluctantly or otherwise, strikes me as very un- Darwinian.

The world would be a bleak place had the great scientists and artists over the millennia not striven to be as far above average as possible. Or indeed higher. The process of natural selection is as much about elimination of the weakest as it is about survival of the fittest. This may be where the analogy in relation to fund management falls down, since underperforming funds and their managers appear to stay in business far longer than in many other industries.

Why is this?

First, selling a fund that has underperformed requires crystallisation of a loss that can never be recovered – a fund is not like a TV that can be sent to the repair shop. Also, selling a fund requires instructions and paperwork that is time consuming – you cannot just tell yourself to buy Brand B next time. Most contentiously, it is possible many investors simply do not know that the fund they own is an under-performer. My first column in What Investment last year was about hubris and how it is the biggest trap a fund manager can fall into. It is tempting after a few years of good performance to think you have it all sussed. But give 1,024 monkeys portfolios to manage and one of them will end up beating the market 10 years on the trot.

Our products in many respects are not the funds we manage but the decisions we make to buy or sell investments on behalf of our clients. I suspect the skill I need to call on at times relates more to being able to persuade clients to stay the course in the face of decisions that are going against us, than it is to the decisions themselves. That, and the skill to stop myself thinking I am skilful, however tempting that may – or indeed may not – be.

Peter Elston is the chief investment officer of Seneca Investment Managers

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N.B. The views expressed are those of Peter Elston at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers Limited and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment. Seneca Investment Managers Limited (0151 906 2450) is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP18 158

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