Passive is not inactive
In the long run, clients’ interests are best served if the core of their equity investments is passively managed with an overlay of specialist satellite active portfolios. Over the long term this combination produces better returns at lower cost than traditional balanced management. We provide both passive and specialist active investment services to our clients. A passively managed fund can deliver good performance at low risk and low cost. Over the long term an average passive fund will produce results closer to its benchmark than the average active fund. A number of factors influence this outcome:
q Performance According to a study by The WM Company, over five years the chance of an active fund outperforming a passive fund is around one in four. Over three years the average passive fund is in the second quartile of overall performance and for periods exceeding three years, passive funds have maintained their performance relative to the index while that of active funds fell away. The idea that higher risks bring higher returns also looks highly suspect and the same report claims large deviations from a benchmark are not generally associated with higher return.
q Consistency Passive management produces consistent results. Consistency is important both to trustees of pension funds and to individual savers. Most lay people can work out for themselves that a fund in the top quartile has the potential to fall a long way and that, like anyone, active managers have off days, months or years. Most active managers have proved unable to deliver consistently good performance. Few fund managers have sustained outperformance or underperformance over the longer term. Buying into a particular manager on the strength of outperformance, or leaving one with a history of underperformance could seriously damage an investor’s wealth.
Passive managers have none of these problems. Of course, indexation is itself an emerging science, with many impassioned debates about appropriate indices, dealing strategies and added-value activities such as stock-lending. But in essence the task is simple, replicable and very cost effective. Timing issues become irrelevant, and by definition the portfolio will contain both growth and value elements.
q The weight of money Active managers tend to perform better with smaller funds, while size is no problem for passive funds. The larger an active fund becomes, the harder it is for the managers to deliver outperformance. All too often, due to the weight of money, the fund becomes a closet tracker, still carrying the extra weight of active management costs. In contrast, passive management rewards investors with huge economies of scale. The same tools are used to manage £1bn (e1.7bn) or £50bn, so the larger the fund, the smaller the costs as a percentage of the fund.
q Running costs It is worth examining the relative costs of running passive and active funds, as a portfolio’s running costs inevitably eat into its performance. The direct expenses of running a passive fund are significantly lower because there is no need to pay expensive humans to make quality judgements on what to buy and sell, nor to pay another set of expensive humans to provide the research on which those judgements are based.
In addition, The WM Company says costs of buying and selling securities within a portfolio are around five times more in an active fund than in a passive one. An active manager has to recoup these higher costs before any value can be added to the fund. Considering these points it is not surprising that, according to consultant Watson Wyatt, by 2002, 30% of UK equity assets are expected to be held in passive funds, up from 22% in 1997.
Moving to passive management has profound implications. The chosen benchmark index needs to be inclusive and robust; for example we have our doubts about the retail trackers that restrict themselves to the FTSE 100, not least because of the significant changes required because of old constituents dropping out and new constituents replacing them.
The fund manager cannot sell if things go wrong with an individual company, so he has a strong incentive to minimise the chances of this happening. Finally, it is impossible to outperform the benchmark; thus performance can only improve if the companies which constitute the benchmark do better.
So a manager or client considering moving to passive investment has to ask whether there is anything in the stewardship and management of shares which creates value. Our experience is that companies with concerned and involved shareholders are worth more than those without such shareholders.
In any successful company the board expects to be involved in the management and stewardship of the business.
Shareholders have similarly important, albeit different, stewardship roles to perform.
A passive manager needs:
q to have a clear and comprehensive view of good governance which is well communicated to investee companies and to investors;
q to understand all the companies in which it invests, so that it can identify those with particular problems;
q to apply codes flexibly and with intelligence, vote its shares and discuss its views with the investee company;
q to behave properly and predictably as an owner – particularly in activities such as hostile bids, where the long- term interests of shareholders must come first, and
q to be prepared to be active and proactive
The manager must therefore have an effective governance team with specialist and industry expertise. Portfolio managers and the governance team have to meet frequently both with investee companies and to decide voting policy. Companies with particular management issues must be identified for specific activist involvement.
Passive investment is therefore not an easy option but all the evidence suggests active stewardship is worth it. Independent observers of the investment management scene have made their judgement.
According to consultant McKinsey, investors say they would pay 18% more for the shares of a well-governed UK company than for the shares of a company with similar financial performance but poorer governance practice.
Anthony Esse is marketing director of Hermes Pensions Management in London