Active, Passive or a bit of both?

Tuesday, 25th July 2017 13:15 - by David Harbage

The above question is probably the one most frequently posed by prospective stock market investors – after being encouraged to spread their monies across many assets, and businesses in the case of equity, rather than invest in just a few company shares.

It is to be hoped that individuals with a preference to own particular firms will choose at least a dozen names to minimise the risk of a scandal or other stock-specific risk adversely impacting their portfolio worth. Ideally, stock exchange investors will have some exposure to the overall asset class and perhaps select a few holdings in areas of business where they have greater conviction.

So, in looking for a diversified investment (amongst the thousands available, covering different types of asset with varying aims), what are the options available to the private investor and how could they begin the process of selection? There are three prime types of collective (where investors’ monies are, one way or another, pooled together for) investment. The first is an ‘open-ended’ fund - managing monies, which ebb and flow as investors make introductions and withdrawals (operating along the lines of a traditional unit trust). Secondly, a closed-ended fund, so-called because the fund is not ‘open’ to new monies arriving or leaving, is typically a company structure – such as an investment trust, which are listed on the London stock exchange. The third option can be viewed as a combination of those: an open-ended (to receipt and withdrawal of monies) but an exchange traded fund (ETF).

If the former briefly describes the vehicle or wrapper used to hold the pool of assets, we now come back to the original question and consider the underlying investments. Besides the objective (for example, a focus on capital appreciation or income returns), almost all collective investments will have a benchmark to try and match or beat - in the form of an index, such as the FTSE100, or the peer group of comparable competitor funds. This will be used to assess their success or otherwise, but in addition it will help investors recognise if the pooled investment is an active one (trying to exceed an index’s return) or a passive (matching or tracking an index’s composition and return). So, which should one choose? Best (albeit past) performer, lowest cost vehicle? Who’s more likely to deliver the best returns in future, does it depend on market conditions?

Taking a step back from those considerations, an individual (ideally enlightened by a professional, qualified Advisor) should first consider what sort of assets they wish to invest in – as certain types of fund (vehicle type, as well as an active or passive investment strategy) might be more suitable for particular assets. This article will primarily consider equity (company share) investment - in accordance with LSE website’s focus - in the form of UK larger companies, UK smaller companies and overseas equity. The potential investee stocks for those three asset types will require passive tracker or active fund managers to scan a universe of say 350 (FTSE350 index), 1500+ (FTSE Small Cap and AIM) or 5,000+ stocks respectively. Clearly, the larger the universe is, the more difficult to reliably match or beat.

Past performance represents history and offers the benefit of the ‘rear view mirror’. The reality is that most active fund managers fail to beat their benchmark although a few more manage to consistently outperform their peer group. Overall, passive index-tracking funds tend to outperform active managers (that seek to beat the same index) – recent history shows this to be especially true of United States equity. In part, this can be attributed to the breath-taking rises seen in the biggest, often technology-driven, American companies’ stock prices. Many active fund managers have been unable (or unwilling, perhaps based on concerns of inflated valuation) to match the growing significance of such companies as Apple, Microsoft Corporation, Amazon and Facebook (the four biggest US companies, representing in total more than 10% of the leading S&P 500 index).    

The passive fund does not entertain any such subjective considerations, but rather replicates – usually by owning the underlying assets in perfect proportion to - the benchmark index. One could debate whether it is more desirable to believe in market efficiency (“the market price is right” – for instance Goldman Sachs argued in their week-end research ‘Super Profits & Superstar Firms’ that such firms had benefitted from a trend towards industry consolidation providing a boost to profit margins) and own the index, or follow a contrarian approach. The active manager of equities does not accept that all information and investor views are fairly reflected in share prices – otherwise he or she would own the index perfectly. By overweighting (investing more, as compared to the benchmark) their favoured individual company stocks or industry sectors and underweighting (perhaps to the extent of not owning at all) those deemed less than attractive on fundamentals or valuation, the active fund manager can appear a more sensible option. The fact that one fund manager will adopt an overweight position, in say HSBC (currently 7.7% of the FTSE100 index), and another will choose not to own any goes to show that the price is reasonably efficient or fair being influenced by both buyers and sellers.          

The intuitive expectation that active fund managers can anticipate when a market is high, and take appropriate action to protect the worth of the assets, is likely to be disappointed. Even when a collapse in stock market prices occurs, the fund will almost certainly have guidelines to meet which prevent it moving far from an all-equity composition. To have in excess of 5% in cash is unusual, more than 10% is rare, as these active funds are essentially seeking to (a) invest in a particular asset class and (b) outperform a benchmark index of that asset class, rather than deliver an attractive absolute return. It is for the individual investor to reduce exposure or exit an equity vehicle if they are uncomfortable with prospects for the asset. An active fund manager who anticipates a protracted period of weak actual performance (perhaps in response to a wholly unexpected piece of news or development) is likely to move towards the top of the fund’s cash guideline, but more pertinently will focus on switching out of the most ‘at risk’ (perhaps economically-sensitive or the more highly valued) stocks into higher quality investments. Incidentally, the manager of a close-ended fund has an advantage over the open-ended one in such market circumstances – by comparison, as fearful investors take flight, the underlying assets of an open-ended fund will have to be encashed.  

It is difficult to match an index – even when owning every constituent of that index in perfect weight or proportion - if only for practical reasons; for example an equity index such as the domestic FTSE100 assumes the reinvestment of every company’s dividend on its ex-dividend date, not on the payment date. Passive funds will also incur an annual management fee and potentially other charges (according to whether physical securities or derivatives are used to replicate the benchmark). Taking a look at the performance of one of the largest exchange traded funds investing in UK equity – the i shares FTSE100 ETF, managed by the world’s biggest asset manager Blackrock – it can be seen that this fund’s annualised return, relative to the benchmark index’s performance, has eased over the course of time. Assessing the difference between the ETF’s annualised returns and the FTSE100 index’s, we see 0.04% difference over 1 year to 20 July 2017, 0.22% over 3 years, 0.31% over 5 years and 0.35% over 10 years. This ETF is a £4bn+ fund with an exceptionally low total expense ratio of 0.07% per annum – as compared to many active managers whose collective investment fund would have an ongoing charge of 1% or more.

It is interesting to look beyond the equity class at another ETF within Blackrock’s stable of i shares, in terms of assessing tracker funds’ ability to match the return of an index. The i share £ Corporate Bond ETF currently has 330 individual sterling denominated, investment grade bonds in its £1bn+ portfolio – upon which the world’s biggest passive manager charges 0.2% per annum. The fund’s benchmark is the Markit iBoxx £ Liquid Corporate Large Cap index and, to capture this, the portfolio of bonds’ average maturity is 13.8 years, with a duration (pivotal age) is 9.2 years, its coupon is 5.0%, yield to maturity 2.6% and distribution yield is 3.1%. By country of issuer, UK dominates with 44% of total portfolio worth, with European issuers accounting for 27%, the US with 22% and 7% emanating elsewhere. Critically, since this ETF’s inception in 2004, annualised performance has lagged its benchmark (which, incidentally, changed mid-term) by 0.19%.

The bottom line is that the performance of index trackers will tend to struggle to keep up with their benchmark indices – especially where the fund is lower value (harder to replicate in physical assets, may resort to using derivatives), the target benchmark is large (for instance the FTSE Small Cap index had 591 constituent companies and AIM has another 963 stocks as at 30 June 2017) and the TER or ongoing fund charge is high (anything above 50 basis points, or one half of one per cent).   

Here are a few other passive, priced in sterling, index-tracking ETFs, showing current distribution yield and annual costs, which might have appeal or be of interest:

i shares Global High Yield Corporate Bond - yields 4.9% and costs 0.5%.

Vanguard FTSE UK Equity Income - yields 4.5% and costs 0.22%.

Vanguard FTSE250 - yields 2.7%, costs 0.1%.

Vanguard Developed Europe (includes UK) - yields 3.2%, costs 0.12%.

Wisdom Tree European Equity Income - yields 5.3%, costs 0.29%.

Vanguard North America - yields 2.0%, costs 0.1%

Schroder US Equity Income Maximiser - yields 5.1%, costs 0.4%.

Vanguard Pacific ex-Japan - yields 3.9%, costs 0.23%.

Vanguard All World High Dividend - yields 3.7%, costs 0.29%.

Vanguard All World - yields 2.4% - costs 0.25%.

Looking beyond the passive to active managers, it is a ‘given’ that such funds typically charge higher annual management fees and performance, relative to their benchmark index, could vary significantly from year to year. Certainly there are times when professionals agree that ‘it is a stock picker’s market’ – for instance when there is a clear trend (per UK equities in the second half of 2016, post the EU referendum, there was steady polarisation of £ versus non-£ earners). At other times the opposite is true – a prime example would be when M&A activity increases, as the beneficiaries of such takeover rumour or actual industry consolidation can be quite random.

With the benefit of hindsight, there are periods – perhaps characterised by economic turning points – when an active fund manager can identify the early ‘green shoots’ and increases the ‘beta’ (stocks with greater exposure to market or the economic landscape) within a portfolio. Similarly, but conversely, the manager can anticipate (perhaps via survey or talking to company management) a weakening trend and reduces economic sensitivity within the fund’s portfolio - for example by switching into defensive or resilient industry sectors like water. Besides such considerations, the smart investor will also appreciate that the much lower level of research carried out by professional analysts on smaller companies provides opportunity for the active manager to spot an interesting business or an undervalued one. Essentially the stock market’s ability to fairly value smaller company stocks (which professionals call ‘market efficiency’) is much reduced, and makes a strong argument for an astute active manager over a passive tracker of this segment of UK equity.

A similar case can also be made for global equity funds, whose universe of stocks from which to select is huge, as they endeavour to beat indices featuring a large number of companies. In looking at active managers, the writer has a preference for close-ended funds over open ones in appreciation of their: (i) ability to control the monies in the fund, (ii) typically superior historic returns, (iii) in part driven by a lower charging structure, (iv) listed, rather than daily, pricing with (v) the latter offering an interesting option of considering the discount or premium of net asset value (NAV) versus the share price , to assess valuation appeal. For this reason, while there are many attractive and well-managed open-ended funds on offer, this blog will constrain its view of active collective funds to UK listed investment trusts (IT). In particular, the following assessment focuses on a trust’s relative share price performance - citing track record versus its peer group of other closed-ended collectives with the same investment objective - and, per the ETFs mentioned above, the income yield and annual costs.

The £265m Invesco Perpetual UK Smaller Companies IT return has put it 2^nd out of 15 peers over 3years & 5^th out 17 over 1 year, it offers a 3.4% yield and charges 0.78%, current share price is at a 2% discount to net asset value (NAV).

The £310m Blackrock Throgmorton IT also invests in small and medium size UK companies, was 3^rd out of 15 over 3 years and 1^st out of 17 over 1 year, offers a 1.8% yield and charges 1.3%, shares are priced at a 17% discount to NAV.

The £300m F&C Capital and Income IT’s benchmark is the FTSE All Share index (all fully listed, large and small, UK companies), was 3rd out of 24 comparable funds over 3 years and 4^th out of 24 over the past year, yields 3.3% and charges 0.83%, shares are currently priced on a 0.5% discount to NAV.

The £1.1bn Finsbury Growth & Income IT shares the same benchmark as the F&C trust, was 1^st out of 24 peers over 3 years and 16^th out of 24 over the past year (illustrates how relative fortunes can change); the shares yield 1.9% and the fund charges 0.8%, with the share price currently matching the trust’s NAV.

The £5.7bn Scottish Mortgage IT benchmark is the FTSE All World index, returns have made it 2^nd out of 23 peers over 3 years and 3^rd out of 23 over 1 year, offers a yield of 0.7% and charges 0.45%, currently features low exposure to US equity (44% versus 59% benchmark weight) but relatively high position in China (19%), shares are priced on a 2% premium to NAV.

The £1.5bn Monks IT also invests in global equity, was 3rd out of 23 comparable funds over 3 years and 1^st out of 23 over 1 year, yields 0.2% and charges 0.62%, features same 44% US exposure with 19% in emerging markets, shares are priced at a 1% discount to NAV.

As an alternative, consider the £300m Edinburgh Worldwide IT which seeks growth via global immature entrepreneurial stocks of less than US$5bn market capitalisation (smaller than a FTSE100 index constituent). The portfolio features: US 52%, UK 20%, but no emerging market equity. Returns place this trust 8^th out of 23 peers over 3 years and 6^th out of 23 over 1 year, offers no income yield and charges 1.0%, but shares are valued at a 9% discount to NAV. Interestingly, each of these active global equity funds are managed by the same investment house, Baillie Gifford.  

So, there you have it dear reader, passive and active funds. In terms of reading more to assess the different opportunities – benchmarks, as well as past performance (remember fund managers can change) and costs – fund factsheets are readily available to investigate how tracking funds operate and strategies being employed by active managers by searching the internet. Further detail of portfolios – which range from being quasi-trackers to the very concentrated (limited number of constituents) or contrarian (taking big exposures away from the benchmark index or current consensual views) – and current views or fund activity can be enlightening.