Active versus passive investing – is there even a debate?
Active versus passive investing is there even a debate
?
It seems to be that at a theoretical level the argument is nailed by a simple mathematical analysis. This deserves for a full and complete explanation quite a lot of space but a short summary for this blog will hopefully suffice.
To explain more, let us look at funds investing into the UK stock market focusing on the overall Index.
A passive fund in this arena is likely to be called an All Share Index tracker, and will be designed with very low costs to mirror or track the Index. Low costs are deemed to be below 1% per year. In effect the passive fund buys in very small chunks a slice of all shares making up the sector. Let us assume the costs are actually 1% per year.
An active fund in the same sector or arena will be managed with the Manager looking to pick and choose from the sector (UK All Companies) to maximise returns. The active fund will be looking to buy the best companies, selecting only some of the companies in the sector. These will cost more to run, with an estimated average of around 2.5% per year when all costs are added up.
The sector will therefore be made up of lots of funds, mostly active but some passive (probably split a round 90/10) which constitute the whole 100%. This ignores other investors (i.e. those that are NOT funds) that may hold investment within the sector, but for the theoretical argument this is OK, because there is no evidence that these non-fund players make any material difference.
Assuming therefore that the whole sector is made up of a combination of active and passive funds, we can look at the outcome, which is a certainty (i.e. there is no debate).
The average return achieved by the passive and active funds combined before charges - will have to form the overall return of the market which is also called the index. So the indexed return is the same as the average. Therefore the trackers (passive funds) will return the index less 1% p.a. Look at the funds in sectors and this is generally the outcome, so the evidence supports this.
Active funds will have a whole variety of returns, from exceptional to terrible and most will sit somewhere in between. Before charges are deducted the active funds must also average out around the index return, it is mathematical certainty because the average return of all funds is a combination of the average of the passives and actives and we know the passives are identical (in theory) to the index, so the active funds must also be the same.
However we also know that the actives have a higher distribution in their returns and also they have a higher average annual charge. We also know that small additional differences in charges make quite a big difference over time. Therefore the average active fund return after charges is about 1.5% per year worse than the passives and over time this makes a big difference (about 10% to the net total return over 6 years roughly).
It is often said that only about one in five active funds outperform the index and this is certainly born out by the evidence, so the same is true of actives vs. passives the average return has to be higher with passives. The conclusion of all this? Passives will always on the average outperform actives in the same markets provided their charges remain lower. There is no debate it is a mathematical certainty.
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