Do well-paid fund managers add value in the long run?
By Tim Brear
It's easy to get caught up in the City hype about which investment approach – active or passive – is better. Supporters of each believe their approach is the right one, the one that has the potential to generate the greatest amount of return over the long term.
Active management is simply an attempt to ’beat’ the market as measured by a particular benchmark or index. The aim of active fund management — after fees are paid — is to outperform the index for a particular fund (not to mention other fund managers they may be competing against).
Passive management is more commonly called indexing and is an investment management approach based on investing in exactly the same securities, in the same proportions, as an index.
The management style is considered passive because portfolio managers don't make decisions about which securities to buy and sell; they simply copy the index by purchasing the same securities included in a particular stock or bond market index.
Investors should note the rationale behind active management. There is an opportunity for higher returns compared to a benchmark, but it comes with higher average expenses, potentially increased tracking error and risk of under-performing. Indexes try to mirror a benchmark with lower expenses and relatively smaller tracking errors.
Passive ‘managers’ generally believe that it is difficult to beat the market. Therefore, they essentially offer asset class performance that closely matches an index, for those investors who are unwilling to assume the risks of active management.
Active managers believe the market can be beaten. While they can't beat it all the time, many active managers do believe there are certain irregularities in the market that can be taken into consideration to achieve potentially higher returns.
Statistics appear to support the passive approach and it is easy to become very cynical if you take the time to look at past performance. Firstly it is important to note that there are a few managers (10-15%) that do outperform their index.
The problem is that there are very few that do so consistently and there is no science in choosing those that will do in the future. After all, we are asked to buy funds on a manger’s past performance – we are buying ‘hope’ value. The number of funds that outperform their index declines as time frames are extended to the point where a statistically insignificant number outperform.
Time frame may be a key issue here. The point of a passive approach is to drive out cost. This may be a saving of 2, 3 or 4% a year (it can often be much more!). As Einstein called compound interest the 8th wonder of the world, it is easy to see that, if you can drive out this sort of saving each and every year, without damaging performance, the longer term benefit can be significant.
In the short term, there are theoretically steps that an active fund manager can take which are not options in a passive approach. Whether these are regularly or ever taken is another matter!
In my view, if you are investing for the long run you can basically control two things; diversification and fees.
So, buy well diversified index funds. Given the marketing budgets of the fund management houses and the smaller (less expensive) voices of passive providers, is not surprising that the debate is not out on the streets in the UK yet. It’s already a lively one in the US where Warren Buffett is recently quoted as saying ’When the dumb investor realises how dumb he is and invests in an index fund, he becomes smarter than the smartest investor’.
Tim Brear is a Certified Financial Planner and Director of Chartered financial planning firm Brook-Dobson Brear in Harrogate. www.bdbfinancial.com.
Article from Citywire.co.uk, 29 May 2009.