KEY POINTS:
Nothing polarises financial planners more than a discussion of the merits of active versus passive investment management.
Actively managed funds buy and sell stocks depending on their fund manager's view whereas a passively managed fund just owns all the stocks in the index it tracks.
On the active
side, protagonists will introduce as evidence the fact that fund managers in New Zealand have outperformed the index in the short and long term while also insisting that in a down market active investors will always beat the computer because they can hold cash in their portfolios or even go short.
On the passive side, advocates will point to long-term historic data in the US and UK which shows that in aggregate active fund managers underperform by the extent of their management fees.
Obfuscating objectivity further is the fact that active funds generally pay higher fees to financial planners than passive funds including ongoing trail fees of up to 50 basis points a year - twice the total expense ratio of many trackers.
Stockbrokers, too, are known to get hot under the collar about the subject and, while often publicly deferring to their active manager institutional clients, most will privately admit that passive has a place in larger portfolios even if they would secretly much prefer you bought their 10 favourite stocks.
Whatever your view, the simple fact is that institutional investors worldwide index a big part of their share portfolios - up to 40 per cent or so by value in the UK/US - but at the same time allocate an increasing amount of cash to the opposite end of the passive/active continuum - hedge funds.
Hedge funds promise to outperform the market (create alpha is the terminology) but in return charge much higher fees.
Caught in the middle, apparently, are fund managers who charge higher fees than index funds but just track the index - that is, produce the market return, known as beta.
A new paper by two academics at Yale University has added some interesting new facts to the active versus passive debate particularly as it relates to the problem of investors paying for alpha but getting only beta.
Martin Cremers and Antti Petajisto of Yale's International Centre for Finance looked at equity-oriented managed funds in the US on the basis of the extent to which each fund's share portfolio differed from the benchmark index.
For example, in New Zealand Telecom is about 18.3 per cent of the NZX50 so a New Zealand share fund that had no exposure to Telecom would be deemed to be more active than one that had a 12 per cent exposure to the telco.
The analysis gets interesting when the Yale researchers found that active management predicts fund performance. They found that the funds with the highest Active Share significantly outperformed the benchmark index both before and after fees while non-index funds with the lowest degree of Active Share underperformed.
The researchers also found that the larger a fund is the less active its management, that a significant number of large funds are closet indexers and that managed funds, since 1980, have become less active.
The researchers further noted that portfolio turnover for the sample of US mutual funds averaged 95 per cent a year and varied from a low of 13 per cent for index funds to 195 per cent for an actively managed fund.
They commented that closet indexers might mask their passive strategies with portfolio turnover.
The Yale analysts concluded that if you are trying to find a fund manager who will outperform, you are best to invest your money with one who is highly active, has limited funds under management and the best historic one-year performance. These funds outperform their index by about 6 per cent a year.
So what, if anything, does this mean for mum and dad living in Auckland and investing for their retirement?
At the risk of grossly simplifying the Yale analysis and possibly bringing the local financial community into disrepute, we can follow the Yale exercise for New Zealand-oriented equity trusts by assuming that a fund's relative exposure to Telecom, New Zealand's largest listed company, is a proxy for the extent to which it is active or not and compare this with 5-year performance. (See table.)
The results certainly seem to support the Yale analysis with funds like Fisher and NZ Investment Trust doing well and the likes of AMP, Tower, Asteron and ING nominated as potential closet indexers.
Antti Petajisto, the co-author of the study, cautions that there is a risk that the performance difference is just capturing the underperformance of the telco sector.
Nevertheless the results are encouraging and maybe give the local unit trust research houses the opportunity to do some useful further work in between choosing the latest incarnation of Fund Manager of the Year.
* Brent Sheather is a Whakatane-based investment adviser.
