Passive or active?
It's a fierce debate in the funds management industry, and it's been going on for decades.
The active fund managers — the ones who analyse individual stocks and single them out for buying or selling — are at loggerheads with the passive fund managers, who allocate funds in proportion to stocks' weighting on an index.
Steffan Berridge, senior investment strategist at Kiwi Invest (formerly Gareth Morgan Investments) is in the active camp.
Berridge, who has a PhD in financial mathematics, acknowledges passive investing is one of the cheapest ways to access equity markets globally and has helped to drive down fees across the board.
"Passive investment managers and their suppliers have gone further than just offering low cost products, however, and have portrayed actively managed portfolios as a bad option for investors," Berridge said in a paper published this week.
"We disagree, and believe headlines supporting passive investing are largely driven by passive investment managers and index providers looking to frame the debate to their own advantage.
"We believe that the research behind the headlines is inadequate and highly biased, and a poor source of advice for investors — but a frequent darling of the press, due to its headline-grabbing sense of distribution," Berridge says.
Making things worse, he argues, the bull market of the past nine years has masked the risks of passive investing.
"We think investors moving to passive funds are going to be disappointed in the long run, and that the headlines that have driven the move will eventually prove to have been incorrect."
Unsurprisingly, Berridge says that while passive investing can be a better option than just leaving money in the bank, it is also a lost opportunity.
"As with many other products offered at a discount, passive investing comes at a price," he says.
When passive funds invest in markets through vehicles such as exchange-traded funds, there's a good chance an S&P index will be at the core.
America's S&P 500 index is probably the most widely tracked index in the world and S&P Indices is the largest index provider.
S&P itself does not sponsor financial products, but it licences its indices to people who do.
Craig Lazzara, managing director for investment management strategy at S&P Global, is well-versed in the arguments for and against.
Naturally Lazzara, who was in New Zealand to speak to an event sponsored by New Zealand index fund manager Kernel, is in the passive camp.
The active/passive debate goes back at least 50 years — dating back to when passive vehicles were created in the 1970s.
"All of it springs from an observation or a set of observations that in most markets, the majority of active managers underperform the benchmark that is appropriate to their investment styles," Lazzara told the Weekend Herald.
S&P publishes a report called SPIVA — for S&P Indices versus active — which he says addresses the issue.
"The evidence, not only from our SPIVA report but from others as well, is very strong.
"There are two conclusions. One is that in most markets, the majority of active managers underperform most of the time.
"The second is that when you find a manager who has done well in a particular period of time — say one to five years — that is not predictive of how they will rank in the subsequent period of time, so there is very little evidence of genuine skill in active management.
"And when you find evidence of success, generally it tends not to persist."
Passive fund detractors say that it's brainless; passive funds don't discriminate, so investors will at times be unwitting owners of stocks that may be having problems.
Lazzara is well used to addressing the detractors.
He points to the late Jack Bogle — who founded the giant US investment organisation Vanguard Group, and is credited with creating the first index fund — who endured mockery for years.
The critics labelled his fund as "Bogle's folly". Today the big three — Blackrock, Vanguard and State Street manage about US$13 trillion in funds.
"Jibes against indexing go back many years," says Lazzara.
"The ultimate answer is to ask investors to look at real performance data.
"If you look back over 5-10 years, the evidence is very strong — that an unmanaged index fund would rank in the upper 20 per cent of all funds available."
But isn't the success of the passive strategy simply a reflection of a bull market that has gone on now for the thick end of 10 years?
"I don't see it that way. Remember, indexing started in the 1970s after a disastrous bear market.
"It is certainly true that in the last 10 years that indexing has grown.
"It is certainly true that over the last 10 years markets have been up. I don't ascribe a cause and effect to that at all.
"The data that we have on that suggests that active managers can do somewhat better when the market is declining, but certainly the majority do not do better.
"The idea that suddenly index funds will underperform and that active managers will somehow be vindicated in the next bear market ... There is no real evidence of that in history."
When a stock is about to be included or excluded in an index, doesn't that produce undue volatility in the company's share price?
"When a stock comes in, there is some evidence of a temporary move up. It's usually small and it doesn't last".
Is the extraordinary growth of passive funds acting to perpetuate this unusually persistent bull market?
"They aren't connected the bull market in a distorting way," says Lazzara.
"It is certainly the case that money has flowed into passive funds from active — driven mostly by the disappointing performance of active managers.
"If there is a distortion — and I don't think there is — the distortion arises because people chose to put money into equities."
Lazzara also says the assumption that passive funds do worse than active funds is not supported by the data.
He estimates that fully passive index funds manage about 20 per cent of the US stockmarket by value.
In management fees alone, he estimates the passive funds save investors more than US$$20 billion annually in fees.
The growth of index funds and passive management has been one of the most significant developments in modern financial history.
He said it's not surprising, therefore, that active managers would mount a stubborn resistance to the growth of index funds.
"Some of their commentary is risible and can easily be dismissed, but we take issue even with the more substantive complaints."
He says that if the equity market is in a bubble, it was not inflated by index funds and there has been no evidence that passive management has damaged market efficiency.
"The growth of index funds in itself evidences the value that passive management delivers to the investment community," he says.
"We anticipate that index funds will continue to take market share from active managers." So who's right — active or passive?
Investors will be the judge.