How many of us have attended a musical, sporting or school event and thought to ourselves ‘if I leave a few minutes early, I can beat all the traffic’. A good idea in theory, but often you discover everyone else was thinking the same thing. Our plan only works when just a few people are thinking that way, but not when everyone at the event has the same idea.
Staying with this theme, rather than wanting to leave early, let’s suppose the school play we are watching is wonderful and a thoroughly enjoyable interpretation of James and the Giant Peach – your favourite book as a child! You become so engrossed in the performance that you decide to stand on your chair to get a better view of events on stage. This clearly works for you, but if the rest of the audience do the same, it results in an obscured view for attendees. Therefore, what might work for one individual is not effective for the whole crowd.
Both of these are examples of a phenomenon called the ‘fallacy of composition’, which is defined as “the error of assuming what is true of a member of a group, is true for the group as a whole”. For economists, this fallacy is used to interpret a number of observed events and helps explain why some perfectly rational and sensible decisions taken at the micro level – i.e. by individual households, businesses or governments – can have disastrous consequences at the macro level for the domestic or global economy. Two very topical examples are;
- During an economic crisis, a sensible household will reduce spending and save as much as possible to prepare for the uncertainty that lies ahead. However, if all households take this action, sales will decline and businesses will struggle, ultimately leading to further unemployment and a deepening recession. An action, that is clearly sensible for any one household, runs the risk of harming them all.
- Governments can use tariffs to reduce the level of imports and provide protection for local manufacturers. If, however, every country takes the decision to impose their own tariffs, world trade will decline and all nations will be worse off. What economically (and politically) works for one country, leads to damaging consequences for the global economy.
Being aware of this phenomenon, we have asked ourselves…
Does the fallacy of composition apply to the current active v passive debate?
The rise of passive investing currently looks unstoppable. Since 2008, assets in exchange traded funds (ETFs) have increased from US$772bn to almost US$4trn, according to figures from BlackRock (the owner of iShares). We have no intention of listing the benefits supporters of passive investing extol; firstly, because many thousands of words have already been written on this subject and, secondly, the majority of these are well founded. Instead, we would like to present the case for why – despite these stated benefits - we firmly remain supporters of active management. The foundations for this mind-set are based on two pillars; one being financial market related and the other centring on our search for alpha.
The principal role of financial markets is to evaluate the marginal return on capital for different assets. This is done through a ‘price discovery mechanism’, with the ‘right price’ identified through a system of constant trial and error. This price discovery relies on a group of independent active fund managers, each undertaking their own analysis, before deciding whether to buy or sell. The underlying price is a function of the return on capital and of the expected growth rate of this return. In theory, capitalism fosters economic growth through a process described as ‘creative destruction’. Put simply, businesses that have a high return on invested capital have greater access to capital; those that do not, are starved of capital and fail.
Passive, or index, investing grossly distorts this efficient allocation of capital as there is no attempt at price discovery. The only thing that matters is the relative size of the asset; the bigger the market capitalisation of a company in an equity index, the more an investor will own. This ‘momentum-based’ approach to investing can be rewarding for some in the near term, but if followed to the ‘nth’ degree by all investors, the resultant misallocation of capital would lead to a recessionary environment. To us, this clearly meets the fallacy of composition definition and would be very damaging for the long term prospects of societies around the world.
In many ways, this argument naturally leads to a conclusion that an equilibrium point exists where investor flows will be balanced across active and passive solutions. Too much into the latter leads to a mispricing of assets, which is exploited by skilful active managers who, in turn, should then outperform the indices being tracked by the passive investors – delivering alpha - leading to a flow of capital back into active funds. In efficient markets, if this flow becomes overly extended, the opportunity for active managers to outperform wanes and monies head in the opposite direction.
The most important word used above is alpha – the excess return over that delivered by the index, or benchmark. Finding managers able to consistently deliver alpha is our raison d’etre and is at odds with the supporters of passive investing who believe alpha is, more often than not, a product of luck rather than skill. Moreover, they also believe - irrespective of this debate - the price paid by the investor to receive this alpha is far too high and the compounding effect makes passive investing a far more cost efficient approach to making money.
In reply to this, we continue to develop our analysis of fund managers to ensure the quantitative metrics used help us disaggregate, where applicable, lucky alpha from skilful alpha. Additionally, our routines ensure we focus on the long term consistency of alpha capture. The usefulness of these metrics is very dependent on the benchmark used – alpha can only be properly assessed when it is measured against a relevant benchmark; this might be market related, cash based or volatility referenced.
When alpha is present, the argument it is diluted, or even negated, by fees was once valid, but not any more. There is a structural shift underway, driving down the cost of fees in the active fund management space, resulting in a much narrower spread between the cost of active and passive investing. There is no doubt, the success of the passive fund management industry has caused this price reduction and this provides further evidence that the equilibrium between the two styles will naturally be found.
A final point we would like to make is the clear evidence passive investing using bond indices is not working for investors and - it could be argued – is a deeply flawed approach. In contrast to passive equity investing, from a performance perspective, active bond funds have largely outperformed their median passive peers and, according to PIMCO (“Bonds are Different; Resolving the Active versus Passive Debate”, April 2017), there are a number of reasons why what works for stocks, does not work for bonds. These range from the large proportion of noneconomic bond investors, through to technical issues like benchmark rebalancing frequency and turnover.
What does all this mean for portfolios?
As stated earlier, we are firm supporters of active management and believe skilful managers are out there. We do, however, recognise there are characteristics of passive investment vehicles that we like and we also acknowledge they can add value to our investment process. The systematic approach to the construction of ETFs is one such example and the removal of the behavioural bias to ‘like’ an active manager and let this emotion discount the cold, hard reality of poor performance is another. All too often, this can result in staying invested when capital should be rotated elsewhere. The ability to quickly execute and express tactical investment decisions is also a very valuable feature of ETFs.
Active management is our thing, but we know this is not for everyone and we do manage a passive discretionary strategy for those who sit on that side of the fence. Our US dollar based ETF Growth strategy seeks to exceed a US inflation plus 3% performance benchmark over a 7 year plus time horizon. Performance has been solid, delivering *6.07% p.a. versus a benchmark return of 4.65% p.a. How does this stack up versus our predominately active manager populated Growth strategy? Comparisons are never easy, given this is a sterling mandate and has a longer track record. Nevertheless it has annualised *6.33%, versus 4.78% for its UK inflation plus 3% benchmark. Pretty much neck and neck so far, although if we are to face more sideways trading markets, where stock picking is key, then perhaps now is not the time to follow the herd. Perhaps more pertinent, if the trend for passive reverses, then being out early will likely prove prudent; as liquidity may be challenged if everyone heads for the exit at the same time.
*Includes both model and composite performance data.
Julia Warrander and Russell Waite
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