Active vs passive management

With the quarterly review of investment returns, the old rivalry between supporters of actively and passively managed funds once again emerges. Supporters of passively managed investments base their arguments on the view that markets are efficient and equities are always priced correctly, that market returns are the average returns of all market players and that active managers generally underperform passive managers due to the higher cost of active management.

According to Johan Pyper, Plexus Asset Management’s head of research, the arguments are no longer this simple. Until recently, passive management was characterised by funds called index trackers. These funds are constructed according to the traditional market cap indices and aim to track an index to equal the index return at low cost,” he adds.

“With the development of ‘more clever’ indices, such as fundamental indexation, it was proved that markets are not that efficient. Portfolios with the potential to outperform traditional market cap indices at the same low cost were constructed according to fundamental indices,” says Pyper.

The types of funds now involved in the argument are:

· traditional index trackers, constructed according to market capitalisation;

· new trackers, constructed according to fundamental factors; and

· actively managed funds.

“It would thus be incorrect to refer to passively managed funds without mentioning how the funds are constructed,” says Pyper. “Similarly, it would be wrong to refer to trackers without stating the type of index being tracked.”

Does this mean traditional index trackers are becoming obsolete and will disappear? It is hoped not. An analysis by Plexus Asset Management of the returns of the different types of funds shows that traditional index trackers still play a role in an investment portfolio.

“The return profile of a fund that tracks the FTSE/JSE All Share Index, and is constructed according to the market capitalisation of the index, can be expressed by its correlation with the index. It can be graphically illustrated as a 45-degree line on a graph. If the index returns 10% in a particular month, the return of the tracker will also be around 10%,” explains Pyper.

The return profile of actively managed funds differs from that of these trackers, however, it is similar to that of passively managed funds that track fundamental indices. “This is to be expected, as both of these fund types are constructed according to fundamental factors that differ from market capitalisation,” he says. “Passively managed funds that track fundamental indices and actively managed funds can thus be grouped together,” he says.

The Plexus analysis shows that actively managed funds tend to outperform index trackers when monthly equity returns are less than 2,27% a month. When returns exceed 2,27%, index trackers tend to outperform actively managed funds,” says Pyper.

Further analysis of the monthly returns on equities confirms this observation. When the returns were divided between bear and bull markets (recovery phase and the subsequent rises), “it is clear that index trackers generally outperform actively managed funds in bull markets and underperform these in bear markets,” says Pyper.

Looking at maximum returns per month, index trackers’ maximum returns per month exceed those of actively managed funds in both bull and bear markets.

According to Pyper, this is because active managers can include more defensive shares in portfolios and may have greater exposure to cash in times of negative market returns. “On the other hand, any cash required to maintain liquidity in portfolios (for withdrawals and trading) has a drag effect in times of strong positive returns,” he says.

Another interesting observation is that the monthly market returns were less than 2,27% per month in 55% of the months and exceeded 2,27% per month in the remaining 45% of the months.

“It thus makes little sense to argue about which management style is better,” says Pyper. “It is more meaningful rather to construct a portfolio that comprises a core of good active managers, including an index tracker that tracks a fundamental index to reduce costs, and a traditional index tracker to share in the strong returns it delivers in especially bull markets.”

When investors become concerned about markets and want to defensively position their portfolio, they should switch the traditional index trackers to a combination of good active managers and funds that track fundamental indices. This is preferred to trying to time the market and continually switching between equities and cash.

In the graph below, the return profiles of index trackers and actively managed funds intersect at the blue line, which represents a monthly return of 2,27%. This means that actively managed funds tend to outperform index trackers when monthly returns of equities are less than 2,27% a month (green line is above black line). It thus also means index trackers tend to outperform actively managed funds when monthly returns exceed 2,27% (black line is above green line).

 (Click on image to enlarge)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Table A

When the monthly returns on equities are divided in bear markets and bull markets (recovery phase and the subsequent rises), findings clearly show that index trackers on average do better than actively managed funds in bull markets, but do not do as well as actively managed funds in bear markets.

 

 

 (Click on image to enlarge)

Table B

Looking at maximum returns per month, index trackers’ maximum returns per month exceed those of actively managed funds in both bull and bear markets.

 (Click on image to enlarge)