Active v passive investing

Last time I covered what your first investment might be. It will almost certainly be an ISA (Individual Savings Account) and investing in to a stocks and shares tracker fund which looks to match the FTSE100 index.

I mentioned that trackers and active managed funds are different and that I would explain a little more about these funds in this episode. Before I do, I want to cover “pound cost averaging” which also got a brief mention.

When you invest a lump sum you can get fretful to the point of doing nothing because you worry about whether the markets are going to collapse the day after you invest. With predictions aplenty over the last two years about stock market crashes caused by global recession, trade wars, high borrowing and Brexit, it is understandable if you feel that concern right now. But, if you hold off waiting for the right moment you need to know when that right moment comes around. There is a graph of the Dow Jones index crashing in 2008/2009 in the transcript. In the shaded area there are at least four points where you might have assumed the market has reached bottom and only one was right.

No one buys at the bottom and sells at the top of the market consistently! You can buy cheaply during a crash because inevitably markets are oversold, prices fall too far. That is not buying at the bottom but buying when the prices are below a reasonable level. But knowing when they are cheap means monitoring the market regularly and being properly informed. If you have a lump sum to invest and are worried about the market crashing you can invest your lump sum in stages to ensure that not all of it will suffer a loss of value. If, for example you invest in four chunks every six months you will buy at four different prices. Because crashes are rapid drops in prices and typically last 18 months, the odds are very good for your second third and fourth chunks doing well. Check the graph of the Dow Jones again and see how you would have done buying at the low prices post-crash and how the market performed afterwards.

If you are investing monthly in your ISA into stocks and shares, you will automatically benefit from buying in chunks. Each month you invest at whatever the market price happens to be. If the market goes down, you buy more of the underlying stocks and shares than you did the previous month. When the market recovers you enjoy the value of the higher price on more shares. As long as the long term trend is upwards (and it has been since the markets began) you will be fine!

If you can put up with pretending you are investing in Aussie dollars you can see how it works using a calculator online – click here

So, if you are investing long term with a monthly sum you should smile when you read about a stock market crash, it’s good news for your future wealth!

Back to trackers and actively managed funds. A tracker, also referred to as a passive fund, simply seeks to copy the index it is benchmarked against. There is no attempt by the fund manager to buy or sell stocks when they think they are under-or overvalued. The fund either buys all the constituent holdings of the index in proportion to the amount of the index they represent or it seeks to replicate their performance. An active fund manager seeks to outperform its benchmark. The benchmark may or may not be an index. An active manager will seek out assets that they believe will achieve that outperformance.

So which is best? The financial services and investment industry are unable to decide.

Trackers are cheaper, they don’t have to pay for a fund manager or the research team that goes with them. They automatically buy or sell stocks as the constituents of the index change. For example the FTSE 100 changes quarterly, companies that are falling value drop out and are replaced with companies entering the FTSE100. Some will go in and out of the FTSE 100 such as Easyjet have done very recently. Also there will be companies that stay in the index but go up or down the rankings as their capitalisation increases or decreases. Capitalisation is the share price multiplied by the number of shares in circulation. Trackers therefore need to get rid of shares in companies that drop out of the index and buy the ones that enter it. They also need to adjust their holdings of the companies that increase or decrease their capitalisation – they need to buy more or sell off.

Active managers will be given a mandate. The mandate states what assets can be held, shares, gilts, bonds and so on. It will dictate how much of these assets can be held, usually in a range of minimum and maximum percentages say 30% to 50% in shares. It also sets the benchmark for performance. The manager must adhere to the mandate.

People have an image of a fund manager as someone on two phones and three computer screens all day buying and selling investments in a manic, adrenalin-fuelled frenzy. The reality is that active managers work in offices that are more like libraries! They are analysing research papers, poring over data and occasionally going out to meet the senior managers of the companies they are looking at as potential investments. The best managers will buy and hold, often for significant periods of time. Active funds are almost always more expensive than their nearest tracker equivalent, often substantially so.

Not all active managers are actually active managers! Just last week the Financial Conduct Authority fined Henderson Investment Funds ltd £1.9m for running a fund that was supposedly active but in fact was little more than a tracker nut charging for it as if it were actively managed.

How does that happen? The fund manager is given a benchmark, say the FTSE100, and they decide that they don’t want their fund to end up well below that. They are fear driven. Possibly because they are set targets for performance that meant their bonus or even their job is at risk if they miss them. The fear makes them overcautious and they take only small bets against the market. What that means is that they hold largely the same stocks in the same proportion as the index and only tinker around at the edges. The performance will be very similar to the FTSE100 except for the charges on the fund, which being higher because it is an active fund, mean you will see underperformance over the long term. It is great to see the FCA finally take action on these fund managers.

Some active fund managers set up a portfolio which is very different from the FTSE100 and you might think that this will solve the problem. However, there are times when the underlying holdings in the fund will replicate the same performance as the index rather than outperform. This can happen when the holdings are closely correlated to the index. This correlation means that there is close relationship between the holdings of the fund and the holdings in the index and that they will behave in similar ways. For instance oil companies are a large constituent of the FTSE100, so buying shares that are not in the index but are affected by movements in the oil price in the same way as oil companies is likely to give similar behaviour patterns.

Good active managers, according to research, have an active share ratio of at least 60%. What does that mean? After all I have promised to take out jargon! The Active Share ratio measures how much a manager diverges from the benchmark index by holding or size of holding. If you had a fund with all 100 of the FTSE100 constituents in the same percentages as the index your active share ratio is 0%. By diverging from the index you increase the active share ratio.

Examining 2,650 funds from 1980 to 2003, Cremers and Petajisto (both work at International Center for Finance, Yale) found the highest ranking active funds, those with an Active Share of 80% or higher, beat their benchmark indexes by 2-2.71% before fees and by 1.49-1.59% after fees. Funds with low active share ratios tend to be closet trackers, the ones that underperform.

High performing active managers will typically hold far fewer shares in their portfolio than mangers with low active share ratios and will hold stocks for an average of no less than two years. Several that I have worked with have held stocks for much, much longer.

So which is best?

If you can pick the active managers with a high active share ratio and who are good at it you will do very well. If not then a tracker will usually be better.

But there are issues building with trackers. They have, not surprisingly been growing in popularity. Since 2010, actively managed funds have gone from comprising 75% of all funds to just 51%, while tracker/passive funds have grown to 49%. But this is creating a potential problem. Passive/Tracker funds are now so big that they can drive up the price of a share on their own. Take the FAANG stocks in the US, Facebook, Apple, Amazon, Netflix and Google. In August last year they were responsible for nearly 40% of the growth in the S&P 500 from its low in February. That meant that trackers had to buy more of them because they represented a larger proportion of the index. That in turn drove the price higher regardless of the real value of those companies. If and when they fall out of favour the actions of trackers could drive their prices down below their real value. The outcome is that markets can become distorted when automatic processes buy stocks which are overpriced and sell those that are cheap.

So does that mean you should avoid trackers now? I would refer you back to pound cost averaging which I covered a little earlier.

That is all for now. Thanks for listening and if you like what you heard tell everyone and if not – tell me using the contact page on the website at poundsshillingsandsense.com

Till next time.