Passive investment refers to rules-based strategies which do not involve managers’ subjective judgment, such as adjusting weights of constituents or timing the market. Since passive funds track their own benchmarks and requires management fees, their returns will inevitably underperform benchmarks. However, many advocates of passive investing still insist that even if the passive funds are not as good as the indices, their performance are still better than the active ones. Is it true? We will examine this subject with you today.
Active Managers Outperform in Inefficient Markets
The general view is that the US market is dominated by institutional investors and therefore it is more efficient. Conversely, other non-US regions are less efficient and have more room for active fund managers to demonstrate their talents A research on funds from Schroeder that tracking major indices in the UK and emerging markets shows that there are funds outperforming indices (after deducting fees) at different times, but the ratio is not static (see Figures 1 and 2).
Figure 1: UK percentage of funds outperforming (rolling five years) (as of March 2017)
Figure 2: Percentage of emerging markets funds outperforming (rolling 5 years) (as of March 2017)
In fact, active investment performs well in emerging markets. According to research by Lazard Asset Management, half of the active fund managers outperformed the MSCI Emerging Markets Index at different times (see Figure 3). Lazard attributes this extra return to the active fund managers who are good at stock picking. The mangers can choose more than 2,500 emerging market companies (while there are only 850 companies in MSCI Emerging Markets Index). Unlike passive investing, the mangers can adjust the weights for any securities so as to fitting their portfolios.
Figure 3: Comparison of emerging market active fund managers with MSCI Emerging Markets Index returns (as of the end of 2017)
Active investing has competitive advantages in bond markets, even in US. The active investment products, including mutual funds or ETFs, in US region have greatly outperformed the passive products (see Figure 4). It is because there are a large number of non-economic investors in the bond markets, such as central banks that needs to intervene in exchange rates, or commercial banks and insurance institutions that may care more about book yield or credit ratings than total return. These participants make up 53% of global bond market in mid-2016, thus providing many mispricing opportunities for active funds.
Figure 4: may care more about book yield or credit ratings than total return( as of the end of 2016)
Consider other factors than return
In summary, the propose of active investment is to achieve extra returns. However, before deciding to participate in active or passive investing, investors should first consider their risk-bearing capacity and investment horizon. In addition, apart from taking reference of past returns, investors should also pay attention to the fund’s Sharpe ratio and alpha when selecting active funds as these help to know the fund manager’s ability on risk management and stock picking.