Active vs Passive portfolios

The debate whether active portfolios perform better than passive portfolios has been ongoing for the past 50 years. Even though investors have favoured passive portfolios more recently, active portfolios dominate 89% to 90% of the world’s assets market, even in US equities, according to Alan Wood, head of Institutional Business at Investment Solutions.

However, in 2014 and the first quarter of 2015, passive portfolios outperformed active portfolios. The wide divergence of passive portfolio returns means the choice of passive provider is important.  The performance of a range of comparable risk profiled passive portfolios for the year ended 31 December 2014 are displayed in the table below:

activetable

*Source: Published Fund Fact Sheets of various investment services providers for the year ended 31 December 2014

Considering the past year’s performance, with a limited track record, Wood says that meaningful comparisons can’t be drawn on the portfolios. However, he observed: “Not all passive portfolios are created equally and there are important active decisions that need to be taken when you construct a passive portfolio”. The results show a dispersion of returns in the one year performance during 2014, the lowest performer around 12% and the best performer close to 16%.

ACTIVE OR PASSIVE?: Alan Wood, head of Institutional Business at Investment Solutions. Photo: Provided

ACTIVE OR PASSIVE?: Alan Wood, head of Institutional Business at Investment Solutions. Photo: Provided

Investors have a “flawed” perception that passive portfolios are commodities, simple to invest in, explains Wood. Given the “inferior results” of past years and high fees of active portfolios, investors prefer passive portfolios. Passive providers primarily compete on costs, however, anyone choosing to invest in a passive portfolio needs to dig a bit deeper and understand the make up of the portfolio and not just make a choice based on fees.

Active or passive?

Investors often make decisions based on past experiences, which destroys value as they chase past performance, says Wood. Investors need to have a long term view and invest with a clear objective in mind, not to simply earn the highest possible return. It is like taking a trip to Durban and on the way deciding to change the route to avoid traffic, he explains. Sometimes you’re lucky with your decision. “At the end of the day we all get to Durban, and we all get there within five hours to six hours,” he says.

A passive investment strategy is a good idea for investors focused on costs or are not able to pick stocks or fund managers that can consistently outperform the market over longer periods, explains Shaun le Roux, portfolio manager at PSG Equity Fund.

Investing based on past performance is like driving while looking in the rear view mirror.  It causes a lot of accidents.

The problem with an index-based passive strategy is that you buy a basket of stocks, without considering the price you are paying, says Le Roux. After a period when large capitalisation stocks have had a good run, the investment can be skewed towards a small sample of very expensive heavyweights, he explains.

Active portfolios are not a “slamdunk” decision either, but past performance shows it produces “significant value”.  In South Africa, when measured over the long term, good active managers handsomely outperform their passive counterparts; the trick is finding those good managers. ”

Wood’s main concern is that when investors make decisions solely based on past performance they ignore critical information that could impact future performance. “Investing based on past performance is like driving while looking in the rear view mirror.  It causes a lot of accidents.”

No such thing as passive investing

To throw a spanner in the works, Wood explains that there is no such thing as “passive investing”. Firstly, this investment decision requires strategic asset allocation, which is not a passive decision. There’s no way an investor can make that decision blindly. Secondly, choosing the right passive provider can also materially impact the performance outcome, which in many cases is not understood. “We’re in a situation where internationally huge assets are being transferred into passive portfolios and active managers are struggling internationally and in South Africa,” says Wood.

In South Africa, active managers are taking strain. The true test comes when uncertainty or risk creeps into the system. History has shown us that active managers generally protect as equity markets re-rate downwards.

“Stop chasing returns. Ask yourself what you want to achieve and then decide on the best way to get to what you want to achieve,” advises Wood.

*This article was featured on Finweek.com.

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