The debate over active versus passive appears to be still alive; 2017 saw a better year for active managers according to the latest SPIVA performance scorecard , though this comes against a backdrop of severe underperformance over both 5 and 15 year periods. In the latter instance, 92.33% of Large Cap, 94.8% of Mid-Cap and 95.7% of Small Cap fund managers managed to miss their benchmark targets. But last year provided an opportunity for active managers to once again beat the drum and (again) foretell of better times ahead (for them at least, if not their investors).
How do active managers expect to beat their passive rivals? Recall that they believe that by paying close attention to market trends, parsing the data and exercising their professional judgment, they will be able to outperform a specific Index (S&P 500, FTSE 100 etc). They aim to take advantage of other investors’ mis-judgments to buy assets cheap and wait for the market to catch up with their insight. Conversely, they will sell overvalued assets and wait for the price to fall back to “fair-value”, pocketing the difference for their investors. What do they look at in particular and how does it help?
Earnings? Clearly a company that earns more than expected (or the reverse), will see a sharp reaction in the share price n’est pas? Well not necessarily.
A study published in Q4 2017 measured the profitability of perfect foresight in terms of Quarterly earnings predictions for US companies from 1986 to 2015 . As the chart below shows, the effect was initially very positive (6% in a quarter is a 26% annualised return) but it has dropped sharply since. The increase in more complex accounting standard and the degree of subjectivity that the US Financial Standards regulators allow management (re: goodwill write-offs, re-structuring charges etc) means that “earnings” have little to do with Corporate performance. So how does it help investors? It is not clear.
Market Timing? Nope. Just like changing lanes in a traffic jam (or in the supermarket checkout queue), buying and selling at the right time is extraordinarily difficult to do successfully. There are thousands of as well (or better) informed investors out there all trying to do this, and they can’t all be right. It appeals to professional vanity that it can be done, but for every Warren Buffett there are hundreds of under-performers.
Macro-Economics? OK, but if the economy grows, so do markets right? No dice there either. According to a landmark study done between 1900 and 2001, (Dimson, Marsh and Staunton -the Triumph of the Optimists, 2002) the correlation between long-term GDP growth and equity returns (in real, post-inflation terms) was minus 0.39, whilst a Northern Trust study  of a slightly wider sub-set (43 countries) showed correlations (R2 in the jargon of economists), of “effectively zero”. This implies that the vast amount of analytical energy expended on these forecasts is pointless.
Current events? Surely, if one can predict the outcome of events, (you may have already spotted where I am going with this!), one would have a distinct advantage; not so fast. Knowing the result of both the Brexit referendum and the US Presidential election would have been of no use, as both (prior to their occurrence) were expected to lead to sharp market falls. They did, but for only a few days in both cases, which turned out to be the low points of the last 3 years. On the other hand, the election of Macron as President of France did lead to substantial gains in both the Euro and most European stocks. There is no consistent relationship between “events” and market reactions (and in a constantly evolving marketplace one could not expect there to be). One needs to know both the event itself and the market reaction to reap the rewards.
It is not that we are against active investing per se; it just doesn’t seem to work, and nobody has come up with a formula that allows anyone to either beat the markets or identify in advance someone else who can. Or, if they have, they are not telling anyone; I suppose that if I knew, I wouldn’t either…
Maybe the difference is not so much active versus passive as high cost versus low cost investment strategies. The solution is in the court of active managers. Should they choose, they could lower their charges to better align themselves with investor interests. So far, the response has been slow, piecemeal and grudging. The market appears to have already spoken; flows have overwhelmingly been to passive funds showing investors get it, even if (so far) active managers don’t.
About the Author
Alistair Meadows is a veteran of stock markets having started his career in the City of London during the heady days of the mid 1980s. After 10 years he moved into (active) fund management in 2000. He repented of his ways and joined EBI in 2014 and is now responsible for helping advisers and investors get the same flow of timely information and quality analysis that is available to professional investors. He qualified as a Chartered Financial Analyst in 2005 and refreshed his skills in 2015 by gaining the Investment Management Certificate. He can be contacted at email@example.com.
The views expressed in this article are the author’s own and not necessarily those of EBI Portfolios Ltd.
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