The editorial below reflects the views of the editorial contributor only and content may be out of date. This article is sourced from a previous JUNO issue. JUNO’s content comes from sources that it considers accurate, but we do not guarantee that the content is accurate. Charts are visually indicative only. JUNO does not contain financial advice as defined by the Financial Advisers Act 2008. Consult a suitably qualified financial adviser before making investment decisions.

By Mike Taylor, Pie Funds

The jury is out. Should investors be using an active fund manager over a passive index-tracking fund manager?

The debate over whether investors should use an active fund manager or a passive (index-tracking) fund manager has been raging among investment professionals since the early 1970s. The commentary from each side is biased, as most authors tend to be in favour of the product they’re peddling.

As chief executive and chief investment officer of Pie Funds, an active fund-management company, you won’t be surprised that my support swings towards active. At Pie, we believe that through careful stock selection it’s possible to outperform an index – the collection of the many hundreds of companies listed on an exchange.

Although I won’t be entirely neutral, I will present both sides of the debate. Then, like any good barrister, I’ll try to persuade you to support my view by picking apart the arguments for the accused and presenting you with unequivocal evidence for the active case.

Efficiency of the stock market

The case for passive investing is founded on the belief that the stock market is ‘efficient’. That means the price you see quoted each day reflects all known information on that company. Every time the price fluctuates, it is because the ‘market’ – the collection of all investors – adjusts the price to reflect new information.

However, in his book Other People’s Money, London School of Economics professor John Kay contradicts this. “If all information were already in the price, what incentive would there be to gather such information in the first place?” he asks.

The stock market is efficient some of the time. After all, we need investors to recognise fair value at some point. However, anyone who’s given the business pages more than a cursory glance will know that prices fluctuate widely, often for no apparent reason. This isn’t the hallmark of an efficient market: it’s the characteristic of an investment that from time to time deviates a lot from fair value.

Active 1 vs Passive 0

The price you pay

Passive investors believe for every winner there’s a loser, in a market comprising a collection of people all striving to achieve the same goal. They call this a ‘zero-sum’ game. Active managers charge a higher fee for their services than passive managers, so statistically the ‘average’ active manager will underperform the ‘average’ passive manager, after fees.

For large markets, historical evidence proves this. For example, look at the S&P 500 in the US. Over a 10-year period, almost 80 per cent of large-cap, active fund managers failed to outperform the index they were paid to beat (according to Morningstar).

What’s more, passive investors argue that at the beginning of the 10-year period, it would be very hard for an investor to work out which active fund manager will go on to beat the relevant index. During that time, the star fund manager could leave and the style of the fund could change, often without the investors knowing.

In addition, the passive investor argues that the higher the fees, the worse off the investor is likely to be. Morningstar research shows that over a 10-year period, funds with lower fees are more likely to outperform the index.

Active 1 vsPassive 1

Small is beautiful

Many from the ‘active’ camp believe their edge comes from focusing on an area of the market overlooked by most investors, and is therefore inefficiently priced. Active fund managers, such as Pie Funds, have proved that the small-company space is a good hunting ground for outperformance.

Research by S&P in 2015 showed that over the previous five years, 70.8 per cent of Australasian small-cap managers beat their index. This is in comparison to large caps, where most managers fail to beat the index.

Other than a lack of investor coverage, the market at the small end of town performs better for a number of reasons, which include:

• Small companies can grow a lot faster than their large counterparts.

• It’s possible to invest and make 10 times your money.

• Small-cap managers are often star performers, who have broken away from banks.

• Small-cap managers often restrict fund size to focus on performance. This is not the case for large managers.

• Small-cap managers have skin in the game. They often have a lot of their own money in their funds.

Incidentally, the long-term performance of small companies as an index is well ahead of large companies indices as well.

By investing in small companies with a skilled active manager, over the long term you’re increasing your chances of beating the general market. Morningstar research states the returns of US small companies were 12.7 per cent a year for the period 1930-2013, versus the S&P 500 index at 9.7 per cent a year. (These figures include dividends, but are not inflation-adjusted.)

Active 2 vsPassive 1

Putting on too much weight

The final point I’d like to make in the debate is the way an index fund works. As a company’s share price increases, it gains a bigger ‘weight’ in its relevant index. But at the height of the dot-com boom in 2000, many internet companies were making no money and yet they had a large weight in the index.

The index takes no account of valuation or company outlook. So you might have a terribly overvalued business with a poor outlook, which you have to own if you are a passive investor.

Active 3 vsPassive 1

The verdict

The market is not efficient all the time and this creates opportunity. The greater the inefficiency – such as with small companies – the greater the opportunity for an active manager to outperform.

If you’re investing in large caps, you’re better off with a passively managed fund or one that has low fees – unless you happen to find a very good active fund manager, which won’t be easy.

However, if you invest in small companies or another niche, you should seek out a skilled active manager.

So a case can be made for both the active and the passive manager; it just depends which area of the market you are targeting.

I leave you with one final point. Not everyone can be Richie McCaw, or take gold at the Olympics, but some people can. It’s the same with investing. Smart people or teams will rise to the top of their game – you just have to be able to spot the talent.

DEFINITIONS

ACTIVE FUND MANAGEMENT: a proactive approach to managing an investment fund. The fund manager’s objective will be to outperform a benchmark index. Active managers rely on research, forecasts, and their own judgement and experience to decide which stocks and other securities to buy, hold, and sell. They will trade more frequently than passive managers, and their fees tend to be higher.

PASSIVE FUND MANAGEMENT: a style of management where a fund's portfolio mirrors the investment characteristics of an index. The fund manager’s objective is to match the return of the index. Fund management fees end to be lower than for actively managed funds.