# active v. passive investment strategies?



## endowed (8 Aug 2002)

The latest pension fund tables from Mercer show that over the 3 years to July 31,the average and median active funds have done significantly better than the Consensus funds:

* average -1.8%

*median - 2.3%

* consensus - 2.5% (Ir.Life),-3.4%(FF & CL),-3.3%(Hib)

the figures are annualised.

Elan has been a major factor and the cause of the less bad outurn at Ir.Life(they had reduced the Elan content).

There has been a pretty wide acceptance on the part of Brendan (and other regular contributors) of the proposition that passive beats active.It has been put as being beyond debate .

The extraordinary events of recent months & the collapse of several companies which were meaty chunks of leading indices may mean that it is time to re-evaluate what had almost become the 'wisdom'.

It is undoubtedly true that active managers gained some ground by raising cash in falling markets and will quite possibly give this back when the markets turn.


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## PhillySteak (8 Aug 2002)

*Passive <> Consensus*

The most important point to be made here is that passive does not equal consensus. 

Passive (Index Tracker) funds simply aim to track the rise and fall of a particular index (FTSE 100, S & P 500 whatever). The underlying shares are typically market-cap weighted in the construction of these indices.

Consensus Funds aim to aim to track the average fund manager in a particular unit trust sector. Here the holdings of each fund manager's portfolio is given an equal representation in the construction of the tracking portfolio irrespective of the size of his fund. In other words, the consensus fund will provide a return that will find it close to the median of the ranking table at the end of a particular quarter.

In my opinion consensus funds are a waste of time and money as
1) They have none of the benefits of index trackers (low cost, the index beats most fund managers)
2) They will never be among the best funds available as by definition they are aiming to be at the median.
3) There is a lot of drag and cost associated with constantly trying to stay at the median of all other funds.
4) You are getting none of the so-called benefits of active management (fund manager expertise!), but you are paying the full active management fees.

So, calling index tracking into question based on the performance of consensus funds is not comparing apples with apples.

Also, I have to disagree with "It is undoubtedly true that active managers gained some ground by raising cash in falling markets and will quite possibly give this back when the markets turn. "
While it may be true that active managers cashed out at some stage, it's unlikely that they did so at the top of the market, and it's also unlikely that they will buy back in at the bottom of the market. So the real question is did they buy and sell at the right times to more than compensate for the charges and fees that they levy on your fund? I would contend that the answer is highly unlikely to be yes in the majority of cases.

Cheers,

Philly


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## rainyday (9 Aug 2002)

*Re: Passive <> Consensus*

Hi PhillySteak - The Consensus fund has a role for me, in my particular circumstance. It is the only 'non-active' fund offered by the trustees of my pension fund, and it's charges are correspondingly lower than the active funds. Just for the record, the options available to me are as follows;

<!--EZCODE BOLD START-->*   Manager   Fund* * * *             Bid/offer* * * * Mgmt fee*<!--EZCODE BOLD END-->
Eagle Star..... *      Dynamic Fund* * * * 1.44%* * * * 0.55%
Friends First.* * * * Managed fund* * * * 1.50%* * * * 0.50%
Friends First.* * * * Fixed interest.* * * * 1.50%* * * * 0.35%
Irish Life.......        Consensus..... *          0%* * * * 0.40%
Irish Life.......        Secured Perf..* * *       0%* * * * 0.75%
BIAM...........   *     Managed fund* * * *     0%* * * * 0.75%

To me, it makes sense as a low-charging equity fund. 

Are there any purely passive funds that the trustees should be considering?

Regards - RainyDay


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## Squiller (9 Aug 2002)

*Consensus Funds*

A quick note on hoew the Consensus Funds work . . .

Asset allocation - ie the broad percentages invested in Equities/Bonds, Ireland/US/Europe etc - is based on the overall average in the Mercer's survey. As all the other funds in the survey are active, it's probably fair to say that there is therefore an active element to Consensus Funds (albeit based on collective wisdom rather than the fund manager's own choice).

However, once asset allocation is decided, passive investing is almost always used to actually determine the holdings. For example, if the Mercers survey indicates an average of 10% holdings in UK Equities, the consensus manager simply goes off and buys a FTSE-Index tracking fund to represent this portion of the fund. They don't try to replicate the average stock selection decisions of the market. This is one of the reasons for the tracking errors observed (which could be positive or negative - although they're negative at the moment, they have been positve in the past).

I think the debate on passive v active so far has missed a major point - some managers do "active" well, some don't. Look at BIAM for example . . . I fundamentally believe that intelligent active decision making has to be better than "dart throwing" - you just have to try to pick the managers who are good at it (and, as seems to be the case with BIAM and some others, there are those who do it well consistently).


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## Brendan Burgess (12 Aug 2002)

*Re: Consensus Funds*

If you had looked at the record of Standard Life 10 years ago, it would have been obvious that some active managers were better than others...

Five years ago, if you had looked at the record of Eagle Star, you would have concluded that there were pensions, and there were Eagle Star pensions...

Last year, many intermediaries were recommending Canada Life's Focus 15, based on their superlative performance...

Today, Montgomery Govett and BIAM are outperforming everyone else...

The problem, is that we have no idea who will be the best performers in the future. And all the properly conducted long term studies, show time and again, that past performance is no predictor of future performance. It's very difficult to believe this when you look at BIAM's record, but that's what the studies show. 

Brendan


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## raul (14 Aug 2002)

*challenge*

Philly is correct in pointing out that Consensus is not the same as Passive - however as a 'mechanical' asset allocation backing into individual market indices,Consensus is clearly a passive form of management.

Commentators such as Brendan have rightly adverted to previous evidence showing the failure of active managers(collectively) to beat passive management.

I am suggesting that this sub-set of passive management(which affects a great many pension scheme members in Ireland ) has over the last 3 years underperformed.

The number of people in Consensus funds (and Irish Life's horrendously-named 'Wisdomscope') vastly exceeds the number in index funds(as opposed to 'trackers').The facts now suggest that the belief that Consensus almost have to beat active(less transactions/costs/stupidity of active managers ...) needs to be challenged.


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## Dogbert (14 Aug 2002)

*Active v Passive*

Brendan is correct. That's why they insist that all the managers put "past performance is no guide to future performance" on all their literature. Past performance has zero predictive power as regards future performance.

I've posted previously on evidence from the UK that only about 25% of active managers outperform indexed managers over a 5 year period. The data is very consistent.

Incidentally, while Raul is presumably correct with the numbers in the first post on this thread, I don't think his conclusion that it has anything to do with the falling markets and the falling former leaders of those markets is necessarily correct. I recently saw an analysis of Irish Life's consensus fund performance over the down market period (March 2000 to date) and they were ahead of the average (by around 1.5% I think) and fifth among the various managers - only BIAM, New Ireland, Irish Life itself (all heavy value orientations) and Hibernian were ahead of it. So active managers in aggregate don't seem to have been adding value relative to indexes in the bear market phase, notwithstanding that a lot of large widely-owned stocks have been falling spectacularly. Value managers have been outperforming, because value stocks have been in favour.


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## raul (14 Aug 2002)

*doggie*

Yes,the value-oriented managers have been winning the day.Value managers are a perfectly valid sub-set of active managers for the purposes of comparing active with passive.

I confirm that my data is correct.

People are missing the point I am trying to make .

I am challenging the assertion (which has been posted on AAM as virtually unassailable wisdom) that active managers collectively cannot/do not beat passive.

The evidence of the superiority of passive was largely if not wholely adduced during the greatest bull market of all time.We now have new evidence based on a different market environment.I do not know which type of markets we will enjoy for the next 5/10/15 years but I suspect it will be different.

The point about the difficulty of picking which active manager is well made.However, if the starting point is that the majority of active managers fail to beat the passive/consensus alternative,only an optimist would  even  bother trying.....

We have seen that while most of Ireland's active managers were holders of Elan,they were on average under the index weighting.I have not heard of any having had Enron or Worldcom (not something to shout about,so maybe some had...)though a number held Tyco.
Collectively,holdings by active (Irish) managers of the large stocks which 'blew up' were way below the S&P index.The same would appear to be true (looking at the pattern of performance numbers)of collective holdings in Telecoms/Tech.

In summary, I am asking promoters of the 'wisdom' to reflect on the new evidence.....


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## US (14 Aug 2002)

*active -v- passive*

Hi raul

“Yes,the value-oriented managers have been winning the day.Value managers are a perfectly valid sub-set of active managers for the purposes of comparing active with passive.”

No, I don’t think they are.

A consensus fund is designed to outperform marginally the median of all the active managers.  It doesn’t follow that it will marginally outperform the median of any particular sub-group of the active managers.  In particular, if you think that investing style – e.g. the value investors – is going to affect performance (and it may affect it differently in different market conditions), then you would expect that a consensus fund will not (except by coincidence) marginally outperform the median value investor, or the median growth investor, or whatever.  It will do either better or worse than that, depending on market conditions and how well they suit value, or growth, investors.

If you think that value investors’ current edge over other active managers is dependent on market conditions then, for a long-term buy & hold strategy, this information is no use.  But if you’re not following such a strategy and are willing and able to switch from manager to manager (at an acceptable cost, obviously) <!--EZCODE ITALIC START-->_ and_<!--EZCODE ITALIC END--> you think you can identify particular investment styles as likely to outperform in particular market conditions <!--EZCODE ITALIC START-->_ and_<!--EZCODE ITALIC END--> you think you can predict the market conditions in a way which enables you to switch to a manager with the appropriate style so as to take advantage of those conditions then, fine.  That is a rational strategy and, if it works, it will deliver better returns than investing in a consensus fund.  But it is not established as a viable strategy merely by pointing to the fact that, in the recent past, market conditions have enabled value investors to outperform the average of active managers.

Philly’s points about drag is well-made.  The “tracking error”, as it were, will be higher than for a true tracker because the consensus manager lags the other managers in a way which does not arise in a true tracker.  My guess is that that may be what is behind the 3-year figures that raul quoted.


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## raul (14 Aug 2002)

*value etc*

I never put the proposition that 'value' would or would not do better than other style(s).I am not for one instant recommending that anyone try to jump from manager to manager.
The figures demonstrate that the 'value' managers have benefitted from the changed investment climate of the last two years.However I have no idea what style will prevail going forward.

US is taking the discussion down a side road- I am simply asking that people be aware of the facts before retailing the conventional(passive beats active) wisdom.I have qualified this by accepting that Consensus is one form of Passive,albeit the form that affects the most people in Ireland.

In terms of the median growth or value investor(and comparisons therewith) the 'science' of performance measurement and analysis is barely aware of the importance of style.The reality is that most managers would not fit that neatly into either category anyway, even if the Moneymates of this world were sophisticated enough to ask the question.


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## Brendan Burgess (14 Aug 2002)

*Re: value etc*

Hi Raul

I am a bit confused by the various sidelines. Your key argument seems to be that there are some occasions or some market conditions when active managers as a whole outperform passive managers?

You may also be suggesting/implying that some fund managers consistently outperform the average?

I think that you are further suggesting that most of the research was done in the recent bull market?

My understanding is that the research has been going on for about 30 years, through bull markets and bear markets and passive managers outperform active managers on average. 

And furthermore there is no consistency of performance. It is not unusual for a fund manager to outperform for about 5 years and then revert to the mean. 

I don't know of any long term study which has identified a particular fund manager to consistently outperform his peers. There are lots of examples of fund managers who do well for a few years. There must also be periods where the active fund managers on average outperformed the passive fund managers. 

Brendan


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## Dogbert (14 Aug 2002)

*Active v Passive*

Hi Raul,

I'd look at this as follows.

Irish Life's Consensus Fund (the dominant one in the market) has given the following returns over 1, 3 and 5 years, according to Mercer's survey: -17.3%, -2.5% pa, and +4.9% pa. The median active fund returns for the same periods have been -17.3%, -2.3%pa, and +4.0% pa respectively. That's a satisfactory performance for the manager, and a satisfactory outcome for the clients who've chosen this strategy. The 5-year excess return over the median is perhaps a little higher than may be achieved long-term, and the 1- and 3- a little lower, but we'll see. As I said in a previous post, the fund has done its job in good markets and bad. As Rainyday pointed out, it is a low cost option in many (but not all) circumstances.

Over 1 year, the best performer is BIAM (-9.8%), the worst is KBC (-22.7%). There is a category of investor, potentially very large, for whom that range of return is an unacceptable risk to take, and who would prefer the "certainty" of the predictable (relative) return that consensus gives. In that way, it's analogous to index versus active management in a sector, such as US or UK equities. It seems to me, as I've posted elsewhere, that statistically, the odds in favour of indexation are pretty compelling, and that if you do choose active management, you should do so carefully and in the knowledge that you're taking an additional level of risk which may or may not be worth it - ie indexation is the benchmark against which you should judge your active management strategy.

You're right on the style issue. Managers will rise and fall in the tables due to their investment style (that's what has caused at least some of the cyclicality to which Brendan referred), but if it can't be predicted, then that fact has no value to investors other than as a post-facto explanation of events.

As for the lags, which have also come up in other threads, I wouldn't overestimate them. Ask Irish Life what rebalancing they have to do within their consensus fund, and they'll tell you that the aggregate asset mix tends to move slowly and steadily. And also, don't forget there's no evidence that active managers are better at asset allocation than at stock selection, so that lagging their asset decisions may not hurt your performance at all.


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## Dogbert (14 Aug 2002)

*Active v Passive*

Sorry, my last post crossed with Brendan's.

Re-reading the thread, Raul said <!--EZCODE QUOTE START--><blockquote>*Quote:*<hr> The point about the difficulty of picking which active manager is well made.However, if the starting point is that the majority of active managers fail to beat the passive/consensus alternative,only an optimist would even bother trying.....<hr></blockquote><!--EZCODE QUOTE END-->

As regards index funds for US or UK equities, I would regard exactly that starting point as proven. That's what makes choosing active management such a risky strategy, imho. Consensus funds are a newer breed, so I wouldn't regard the case as proven, but I am prepared to accept it as a likely hypothesis, given that (a) it seems to be borne out so far, and (b) it is intellectually explainable.

Interesting article on a related topic (after the first bit) here cbs.marketwatch.com/news/story.asp?siteid=mktw&dist=nwtpf&guid=%7B21CF97F5%2D416B%2D4719%2D938E%2DDE3A6D3B2526%7D.


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## raul (15 Aug 2002)

*respond*

Brendan :

I started by pointing out that in the last 3 years the average active fund has beaten Consensus.

The fact that this co-incides with a bear market is probably significant,however bear markets are part of the investment landscape.(We COE disciples had forgotten !)

I did not suggest that some managers consistently outperform,though indeed some have.

The 30 year research is probably not that relevant to the Consensus investor in Ireland and I do contend that it is heavily skewed by the once- in- a- lifetime bull market.(Rather than keep ploughing it in,fund managers are always tempted to keep some new cash/dividends liquid,which hurts in rising markets.)

I never held out that there was any consistency of performance or any predictive value in the numbers.

Maybe I need to post more clearly,but what I said was that the evidence that active managers collectively fail to beat passive(in the form of Consensus) is not there over the last 3 years.

If the majority of managers fail to beat consensus,those selecting active managers in the hope of getting one of the good ones,are betting against the odds.All I'm saying is that the accepted wisdom may need to be revised.

Dogbert makes a number of points none of which seems to demand an answer.....


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## Paulina Porizkova (15 Aug 2002)

*a V's p*

"Maybe I need to post more clearly,but what I said was that the evidence that active managers collectively fail to beat passive(in the form of Consensus) is not there over the last 3 years."

Raul,

1.Would that be Gross or Net of management charges?

2.What, in your opinion, is a reasonable active management charge in a 'Bear Market' or a 'Bull Market'?


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## Brendan Burgess (15 Aug 2002)

*Re: a V's p*

<!--EZCODE QUOTE START--><blockquote>*Quote:*<hr>  what I said was that the evidence that active managers collectively fail to beat passive(in the form of Consensus) is not there over the last 3 years.

...All I'm saying is that the accepted wisdom may need to be revised<hr></blockquote><!--EZCODE QUOTE END-->

I don't think that these data of just three years of a form of passive management in a small market, do anything to refute the conclusions of the many long-term research studies.

Brendan


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## raul (15 Aug 2002)

*query*

The figures are net of management charges .

There is no reason that I can think of why charges should be different depending on whether markets are going up or down.There is definitely a case for performance-related fees,but these need to be carefully structured from a risk perspective.

In terms of what fees should be,let the market judge what each manager is worth.

Those who offer 'creeping consensus' ( sit pretty close to the average sector weightings and hold lots of stocks),should be cheaper.

Those who are good at (real) active mgt will command a premium.This is borne out by the fact that BIAM,who by most yardsticks have demonstrated that they do active well,has the highest mgt charge.Depite being the most expensive BIAM is ,as I understand it,picking up the lion's share of the money that is leaving other managers.


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## Dogbert (15 Aug 2002)

*Active v Passive*

<!--EZCODE QUOTE START--><blockquote>*Quote:*<hr> Depite being the most expensive BIAM is ,as I understand it,picking up the lion's share of the money that is leaving other managers.<hr></blockquote><!--EZCODE QUOTE END-->

... in the same way as Eagle Star, Standard Life, Friends First, KBC, etc etc picked up significant volumes of business when their performance was top of the cyclical pops over previous periods.

Raul is certainly correct that BIAM is winning most of the active mandates. But the real winners would undoubtedly seem to be Irish Life, who have grown their indexed assets from zero to approx €5 billion over six years or so. Their pension consensus fund, for instance, is already 80% of the size of BIAM's pension managed fund (per Mercer survey) despite having given it probably a 15- or 20-year start.


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## raul (15 Aug 2002)

*success of consensus*

Dogbert is right about the massive growth which Irish Life scooped.

While there was a significant body of people for whom consensus represented a neat solution(in particular the trustees of pension funds),I believe its stunning growth has a lot to do with the failure of active.The disillusionment of people who switched (& were often advised to switch...) to the latest 'hotshot' has also helped. 

As I mentioned earlier,many of the so-called active managers are actually closer to consensus.Their main objective is not to deviate too far from the pack.

Those that are 'active' in the truer sense of what that means have not achieved any consistency.The collapse of Eagle Star's performance was something of a body-blow for active .While KBC's fall from grace is another blow for active ,at least BIAM(with whom I have no connection BTW) is flying the flag with distinction.


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## Dogbert (15 Aug 2002)

*Active v Passive*

Hi Raul,

We're getting pretty close to agreement here.

I think the only thing that separates us is that Brendan and I regard what you term "the failure of active management" to be endemic whereas you locate it on a firm by firm basis. I wouldn't <!--EZCODE BOLD START-->* blame*<!--EZCODE BOLD END--> Eagle Star or KBC from having cyclical periods of underperformance ... it's inevitable, and will inevitably happen to BIAM too. 

The business success of indexation strategies is due to this inevitable cyclicality compounded by a sales/purchase process which focuses on past performance (in spite of repeated warnings not to) and seems almost designed to pick last year's winners.

I stand by what I said earlier. It seems highly probable to me that two-thirds or more of active managers will underperform a good-quality indexer over any long-term timeframe, and nothing you've said makes me think that won't be true of consensus-type indexation too.


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## Brendan Burgess (16 Aug 2002)

*Re: Active v Passive*

It will be great in about 20 years time to review the archives of Askaboutmoney. It will be a historical record of Dogbert's "top of the cyclical pops" with different fund managers appearing to have really cracked active management, only to revert to the norm in time. 

If you look at the vote for the SSIA, you will see a lot of the intermediaries opted for the Focus 15 story and it subsequently reverted. Very few opted for New Ireland/BoI at the time. It's just too hard to pick the winners of next year's top of the pops.

Brendan


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## fk (16 Aug 2002)

*Active V's Passive*

<!--EZCODE QUOTE START--><blockquote>*Quote:*<hr> "If you look at the vote for the SSIA, you will see a lot of the intermediaries opted for the Focus 15 story and it subsequently reverted."<hr></blockquote><!--EZCODE QUOTE END-->

Brendan,

Does this mean that you are extremely confident that the index tracking SSIA will be top dog in 5 years time(as opposed to the F15)?


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## Brendan Burgess (17 Aug 2002)

*Re: Active V's Passive*

It means nothing of the sort. 

It means that index tracking funds are more likely to outperform their actively managed counterparts. But some actively managed funds will ouperform the average. Focus 15 may well be the best performing fund in 5 years time.

Brendan


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