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The active vs passive debate is over

Most active fund managers fail to beat their selected benchmark over time.
Image: Shutterstock

Active fund managers argue that their stock picking and asset allocation skills provide them with an advantage over index tracking funds. In theory this may be true, but in reality very few active managers outperform the index over any meaningful periods.

Three quarters of actively-managed large-cap funds in the US underperformed the S&P 500 benchmark over five and 10 years

“This is rather like the Tour de France cycle race. The rider that wins the overall race seldom wins all the stage races. The same goes for investment. If you stick with passive investment funds, you have a far higher probability of making it onto the winning podium over a reasonable time frame,” says Pierre Cloete, CEO of specialist offshore advisor International Wealth & Prosperity (IWP).

Research shows that 70% of active funds do not survive more than five years, while some indexes date back 100 years.

How fees affect fund performance

Research by Morningstar found that it is virtually impossible to predict which fund will outperform a benchmark over time. But the one thing we know is that the lower the fees, the better the chance of investment outperformance. “All told, cheapest-quintile funds were three times as likely to succeed as the priciest quintile,” according to Morningstar.

The chart below shows the impact of an additional 1% in fees on investment performance of the MSCI World index.

The MSCI World Index returned 154.1% in US dollars after annual fees of 1.5% are deducted (this fee of 1.5% is typical of the average active manager).

These returns compare with 180% in US dollars for the MSCI World Index when annual fees of 0.5% are charged (which is more typical of the fees charged by most passive managers). That’s a substantial difference to investors’ total returns over 10 years.

Source: Morningstar

“Funds charging higher fees are more likely to underperform their benchmark over time. The fact that they are charging higher fees compels them to take on more risk to beat their stated benchmark,” says Cloete.

Flows into US exchange-traded funds (ETFs) over recent years reinforces the argument in favour of index tracking passive funds. The trend has continued into 2021 with monthly inflows averaging $77 billion, up 83% from $42 billion monthly in 2020.

Cloete points out that inflows to EFTs in 2020 occurred during one of the sharpest corrections in stock exchange history.

“What we are seeing is a massive migration to passive funds, particularly at a time of heightened risk. Over the last year, the migration has been from active to passive, for the simple reason that history suggests over time you stand a much better chance of being in the winning quartile if you stick with a low-cost passively.”

Soucre: eft.com

High fees are not the only problem with the active management approach. Active managers have struggled with security selection. This is particularly evident when one looks at the number of portfolios that included failing stocks like African Bank, Tongaat Hulett and Steinhoff. Allocating capital between the various geographies and asset classes is another challenge faced by active managers, says Cloete.

Passive investments are not confined solely to global equity markets.

“Once a client’s objectives and risk profile have been assessed, bespoke passive solutions utilising low-cost ETFs that provide exposure to global equities, bonds and commodities are developed by our investment specialists,” says Cloete.

To see how IWP can assist you in building your global wealth, go to iwpsa.com.

Brought to you by International Wealth & Prosperity (IWP).

Moneyweb does not endorse any product or service being advertised in sponsored articles on our platform.

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