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Active or passive – it’s time to change the narrative

The question around active versus passive managers is subtly but critically predicated on the lazy assumption that it is not possible to consistently choose managers that outperform. By extrapolation, if you cannot choose managers that consistently outperform, then you should settle on passive managers which at least won’t extort as much for the privilege of making less than the benchmark.

But both the premise and (hence) the narrative are flawed.

Re-cap passive versus active

A passive investment such as an Exchange Traded Fund (ETF) is a reasonable starting point to commence the investing journey. It generally charges low fees, is professionally administered, and employs a strong level of corporate governance and oversight. ETFs can also provide a good way to gain exposure to offshore companies and specific thematics.

For these reasons, passive investments provide a good starting point for retail, inexperienced and non-professional investors. 

But there are some limitations. To begin with, ETFs cannot replicate an accumulation index to achieve proper compounding as there are too many moving parts. An ETF still charges management and administration fees. And most importantly, an ETF aims to perform in line with an index – not out-perform the index. And it is this last point which is most critical in the context of long-term wealth accumulation.

 

Re-cap on compounding

If you have followed Katana for a while, you will know of our obsession with investor education, data and the power of compounding. To re-cap a simple but particularly pertinent example, consider the effect of time on long term equity returns.

Over the past 146 years, the ASX has averaged 10.8% per annum when aggregating dividends and capital growth[1]. If an investor was to reinvest and compound their earnings each year, these returns would be magnified. And this increase accelerates with every passing year.

For example, after 10 years of compounding, the returns would be equal to 17 years. If the investor was to compound for an extra 5 years, it would double this to be the equivalent of 34 single-year returns. And adding just another 5 years, would double it again, such that compounding for 20 years would produce the equivalent of 63 one-year returns. This accelerates even further with time.

Source: Katana Asset Management

Why active returns are critical

As impressive as this is, let’s now consider the impact that a good active manager can have through time and compounding. By way of example, we have assumed that an active manager has out-performed by 2.7% per annum net of all fees (Katana has out-performed by ~3% per annum net of all fees for 17 years; please note past performance is no guarantee of future performance).

The extra 2.7% per annum when compounded over time produces extraordinary returns. After 10 years, the active management returns would be the equivalent of 24 years versus 17 years for the index. Over 15 years this would have grown to 53 years equivalent one-year returns versus 34 years for the index. And rather incredulously, if an investor was able to achieve an extra 2.7% per annum for 20 years, this would equate to the equivalent of 107 one-year returns versus 63 one-year returns for the index.

Source: Katana Asset Management

[1] Note past performance is no guarantee of future performance. Dividends have averaged 4.54% per annum since Accumulation Index commenced in 1979; assumed at 4.5% per annum prior to that.

This cannot be ignored.

Good active managers do exist and can out-perform over the medium and longer term. And good active managers do have consistent characteristics that can be identified and assessed. This is not to say it is easy, but it is possible. And ultimately that is what investors are paying advisers and consultants for. To generate performance that they could not otherwise generate themselves through passive strategies.

Over the past decade, better investor education and greater transparency of data has led much of the professional advice industry to think that it is too hard to deliver meaningful outperformance. There has almost been a quasi-resignation that it is too hard to generate sustained alpha, so therefore let’s change the narrative to cost-conscious, passive investing.

But the returns above highlight why advisers are selling short those who rely on them. Morally and financially, advisers owe it to investors to get better. Not to settle for less.

Conclusion

The discussion of active versus passive really amounts to the competence and capacity of advisers, asset consultants and investors to select consistently good managers. The question should really be ‘How do we select consistently good managers’ not ‘is active or passive better’? The impact that genuine and consistent out-performance has over time is too compelling to contemplate anything else for professional investors.

 

Romano Sala Tenna is Portfolio Manager at Katana Asset Management. This article is general information and does not consider the circumstances of any individual. Any person considering acting on information in this article should take financial advice. 

 

18 Comments
Longquest
January 08, 2023

As William F. Sharpe noted in his classic ‘The Arithmetic of Active Management’

‘Over any specified time period, the market return will be a weighted average of the returns on the securities within the market, using beginning market values as weights. Each passive manager will obtain precisely the market return, before costs. From this, it follows (as the night from the day) that the return on the average actively managed dollar must equal the market return. Why? Because the market return must equal a weighted average of the returns on the passive and active segments of the market. If the first two returns are the same, the third must be also.’

https://web.stanford.edu/~wfsharpe/art/active/active.htm

Of course, some active managers beat the market every year, just as some punters win at the casino’s roulette tables every night. But are there any consistent outperformers? Few. Ponder Hamish Douglass, who just got lucky betting on tech and China till his luck ran out.

https://www.spglobal.com/spdji/en/research-insights/spiva/

Finally, has Katana really ‘beaten the market’ for a while? What is its benchmark? Its volatility vs its benchmark?

Philip
January 09, 2023

Check the performance of Chris Cuffe's Third Link Growth Fund, whose objective is to "outperform the S&P/ASX 300 Accumulation Index after fees over rolling 5 year periods. The Fund extensively invests in other managed investment funds run by professional third party investment managers." If anyone should be able to long term outperform by superior fund selection, Third Link should.

Performance vs benchmark (years to November, source: Third Link website)

One year -17.9%, two years -8.0% pa., three years -1.4% pa., five years -1.7% pa., inception (2012) -0.8% pa.



James Gruber
January 07, 2023

My interpretation of Romano's article is different from others here. I think it's less about urging individual investors to choose active managers over passive. It's more about him having a go at advisors for neglecting to do the work on active managers who have long track records of beating markets. He's saying these advisors are choosing the lazy option of passive funds for clients, when they should know better.

Steve
January 07, 2023

There are several active Australian equities managers (including Katana) who, after fees, have all substantially outperformed their relevant "index" over the past year or so, and long term. So it is possible, if you have the right charting software to find them.

Sam Simpson
January 07, 2023

In Australia on a 15 year basis 82.93% of active managers underperformed the S&P/ASX 200 which suggests that very few active managers can produce consistent outperformance. In the US context 89.38% of active managers underperformed the S&P 500®.

The numbers aren't very convinving......

C
January 08, 2023

choose the ones that do !

Dudley
January 09, 2023

"choose the ones that do !":

Better to choose the ones that will.

Barry
January 06, 2023

As George has pointed out, what good is an active asset manager that outperforms if investors can't actually take that outperformance to the bank because the share price is dropping and trading at a discount to the NTA?

Another example is Thorney Opportunities (TOP on the ASX) run by "Australia's Warren Buffett" Alex Waislitz. The share price is 54c today and the share price was 54c nine years ago as well back in 2014. Maybe the underlying investments are performing really well but the discount to NTA means investors can't benefit from the fund manager's performance unless they vote to wind up the fund and return the cash.

SMSF Trustee
January 07, 2023

Barry, you do it by investing in their managed fund(s). Listed vehicles have other dynamics, but your exasperation about not being able to access the superior returns is unnecessary.

The long term, consistent outperformed in my SMSF is Ausbil. Paul X and team are very solid.

S2H
January 06, 2023

My mind boggles that people still persist on picking an active manager. Yes it is possible for an active manager to beat a passive fund, but it is very, very difficult for an active manager to consistently beat an index fund over time. This isn't anything new; Burton Malkiel's excellent A Random Walk Down Wall Street was published in the 1970s. More recent evidence is that it's become increasingly difficult for active managers to beat the market as fewer 'losers' play the game.

Put simply, which bet would you take over a 5 year term? The 1 in 4 chance the active manager beats the ASX 200 or the 3 in 4 in change the index fund wins (per SPIVA data)? If you don't like that bet, how about the 9 in 10 chance the index fund is ahead over 15 years? I'll take the index fund plus I'll chuck in the extra $4000 to $5000 I've saved from avoiding a financial advisor and the ridiculous regulatory costs they've got to pass on.

By all means have a punt on an active manager, just be realistic about where it is likely to end. This isn't a reflection of the ability of fund managers either. But they are starting from behind in a handicap race due to fees.

James
January 06, 2023

Agreed. I recently re-read Jack Bogle's excellent "The Little Book of Common Sense Investing". Highly recommended! In it he basically debunks, sinks and annihilates the claim/myth that active managers can beat the index consistently or even a few years in a row, and the longer the horizon the less likely too!

Sean
January 08, 2023

And if you think all advisers do is pick investments for that cost you have been speaking to the wrong advisers or don’t understand the role.

George
January 06, 2023

There are plenty of examples of active fund managers who have have delivered good results for a while - think Platinum, Magellan and Hyperion as previous stars in Australia - but then go through difficult times. The compounding argument stalls for investors who are unfortunate enough to pick the managers at the wrong time. And if it's true that Katana is a standout, and it's since inception is 17 years, then why does its LIC trade at a 15% discount to NTA, holds only $42 million and requires a buyback programme to support the price. This is an indictment on either the LIC structure, people who invest in LIC's or Katana's promotion of it.

Jack
January 06, 2023

And if you want to invest in the KAT LIC on the back of Katana's good numbers, there is currently one seller with 5,000 shares at $1.12. That will get you set for $5,600 less brokerage. Doesn't move the dial. Needs to improve liquidity but as you say, George, it's a small LIC.

Liam
January 06, 2023

As a retail investor with a SMSF investing directly over the last 25 years I have enormous respect for active fund managers who can outperform over a long period, Romano is part of this group along with Peter Cooper, Paul Moore and many others.
I have never used passive ETF’s as I believe that I can do better myself.

Jeff Oughton
January 08, 2023

Yes - direct well diversified passive portfolio (30 stocks) is very hard to beat - esp after tax.
Not to mention that global asset allocation contributes most to overall portfolio performance over the long run
And of course it’s also about matching with your liabilities/cash flows.

Get the macro right…

Adviser
January 05, 2023

I read the headline and went straight for the disclosure. And sure enough, this article was written by an active fund manager. While I'm sure there are well-reasoned arguments, articles like this are best taken with a large grain of salt.

Researcher
January 11, 2023

Research by Oxford University in the late 90s in respect of asset consultants' ability to pick outperforming active managers, showed that they were "useless" and "worthless" (to use the words of the authors). There is no evidence to suggest that anyone can pick the very few (short term) outperformers.

 

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