Caroline Ritchie: Passive players biggest winners

Caroline Ritchie

ONE of the golden rules in investing has been "historical returns are no indication of future performance."

This line has become the mantra of the funds management industry, part of the furniture, and you will find it at the bottom of every disclosure on every financial proposal ever written. It is so ingrained that we do not question it.

Our learned intuition sort of goes along with it, and we think to ourselves, "well, that sounds about right".

A newer strand of finance theory, called evidence-based investing, does not agree, and that historical performance is a very good guideline to future expected returns. If you examine the "no indication" statement and are a bit of a cynic, which I have done and I am, it tends to look like a throwback from the legal team. It really says "we absolve ourselves if we get it wrong" and "do not blame us."

Given a short enough time frame these are valid points, anything can happen in a year or two. However, if you are talking about your retirement plan of 30 years ahead that's different. You may have already guessed that the evidence basers are more on the side of passive investing rather than active.

The approach to passive investing is to leave things to run on their own, which means you receive the market return. Want share exposure?

Buy an index, like the NZ50, S&P500 or the Nikkei 225. Your returns will reflect the movements of these markets, nothing more, nothing less. The market return is often used as a benchmark by active investment managers, who try to beat it by selecting certain stocks.

The methods by which they attempt this vary from just outright guessing to extremely complicated algorithms modelled by computer scientists. Active funds management, which charges clients fees to access their "talents", is a US$17 trillion ($23.9 trillion) industry. Now, here is big BUT, the largest elephant you ever eyeballed, the fly in your gazpacho: the data doesn't support active managers, on a long-term performance basis, at all. Long-term for evidence investors means 40 years-plus. They've got the information. It is convincing. The niggle that active managers have is time.

You can't make time up and you can't extrapolate it just to fit your fancy fund brief.

It is unlikely to win next to a 100-year index chart. There are one or two big name exceptions who can stand up and say they consistently won against the market over the last 50 years. And they didn't do it by much. More usually, tenure is short in the active industry. Portfolio gurus come and go. Additionally, in a quirk of logic, it is going to turn out that some investors are willing to pay advisers for reasons other than returns. There is psychological comfort from having a face who will do battle for them in the treacherous dens of capitalism. Most of these clients are baby boomers and retirees. As younger investors start to push their money-weight around, there is more interest in profit than tea and cakes at the sharebrokers' office. Outflows from active into passive funds, speeded by automated portfolio software and some fairly hefty and indisputable research, are eating into that big wedge of lucrative active management cake. History, once discarded as no good, has come round to yap at the heels of those who dissed her. What happens next will very interesting indeed.

-Caroline Ritchie is a former AFA, sharebroker and portfolio manager. She runs Investment Stuff, a sharemarket based investment coaching service. Visit her at www.investmentstuff.co.nz This column is not personalised financial advice.