Simon Peile, Head of Investments at Sygnia Asset Management, believes it’s time to review the well-trodden debate surrounding active vs. passive investment management with the benefit of looking at the cold, hard numbers.
“We all know there are lots of active managers in the market. While styles vary, they all exist on the premise that they can deliver returns in excess of a market index by using a combination of skill, insight, and expertise. But simple arithmetic indicates only 50% will outperform, and 50% will underperform. It’s a zero sum game – for every winner, there will be a loser,” says Peile. When fees are included, the ratio is distorted even further. “Fees in the active management space are much higher than in passive,” says Peile. “So for any given year, the majority of active managers fail to outperform the index after fees. The industry is full of intelligent, experienced people, but more than half of them fail to add value to their clients. Why?”
Despite paying a higher fee than what it costs to implement a passive strategy, the costs of getting manager selection wrong can be enormous. “Just look at the dispersion in returns over the last year,” says Peile. “You could end up being a long, long way off the market (average) if you get the decision wrong.”
As an example, for the twelve months to the end of January the difference between the top performing fund (37.8%) and worst performing fund (-5.6%) that Sygnia monitors was 43.4%, in a market that delivered just over 24%. “So it’s a bit of a lottery,” says Peile, “you appoint active managers on the basis the returns will justify the higher fees, and then you expose yourself to the risk of massive underperformance if they get it wrong.”
So why are investors, advisors and asset consultants so confident in being able to pick winners? “I think they are horribly seduced by recent performance. They will typically only appoint managers after seeing sustained performance. Active managers inevitably go through cycles of good and bad performance. Investors will typically miss out on the (earlier) good performance and participate in the (later) bad performance. Investors will tend to lose confidence when their managers underperform and get out after the bad periods. So it’s often a case of hire too late and fire too late,” says Peile. This leads to the bizarre situation where investors tend to underperform the funds they have been invested in.
Contributing to this, is the difficulty attached to evaluating the skill of investment managers. There are many factors that go into performance, and luck can play a large part. “The market rewards different styles at different times, so how do you know if it’s sustainable skill the manager possesses?
Bearing all this in mind, is the whole concept of active management – which entails paying more to carry the additional risk associated with a numerically lower chance of success – justified? (In contrast to the more sensible approach of capturing the market return at a lower cost.)
It shouldn’t be. But there are deep-rooted human characteristics that keep us obsessed with active managers. “We all want to do better than the average,” says Peile, “so it comes across in our investment decision-making. We expect our advisers to be able to pick the best managers and if that fails to materialise, we try again. Both investors and their advisers are more confident in their abilities to pick managers than the results suggest is justified.”
Investors then are no different to people buying a lottery ticket. The sales pitch for active managers is attractive – you cannot win the lottery unless you buy a ticket. “In the same way you are not going to beat the index without using an active manager. But people are kidding themselves. Having the confidence to pick active managers that can deliver sustained outperformance is mostly misplaced when you look at the numbers. It is worth remembering what they say about lotteries: a tax on the mathematically impaired,” says Peile.