The growing opportunity in active investing

Our fund management firm is all about active investing, but we are the first to say that most investors should simply opt for passive investing.

This must sound surprising – and it’s not the only surprising fact you will learn from this article. Whether you are a private investor, a wealth manager, or a fund manager, we are confident that you will not yet be familiar with some of the trends, figures and conclusions of this piece.

In this article, we are going to share with you:

• The fund industry’s dirty little secrets, and why they mean most private investors should buy “passive” investment products only.
• The latest figures about the decline of equity research, and how that makes for new opportunities for those who apply deep, fundamental research.
• One region of the world where this is particularly relevant for investors, and paves the way for generating benchmark-beating returns.

Depending on your interests, you can use the sub-headers to jump straight to those parts of the subject that interest you the most.

And for anyone who is not yet entirely clear about the dividing lines between “active” and “passive” investment, we begin with an overview of the terms and the underlying history.

Passive investing vs active investing 

There is perhaps no greater dividing line in the investment arena today than the one between active and passive investing.

Active investing strategies give individual portfolio managers responsibility for actively selecting individual securities with the aim of outperforming a benchmark or index (or sometimes of simply achieving an absolute return target).

Passive investing strategies, in contrast, use a pre-determined set of rules to replicate as best as possible the performance of an index or a representative sample of that index.

The move towards passive products was born in the 1950s and ‘60s. Back then, Eugene Fama’s efficient market hypothesis (EMH) began to question the ability of human beings to consistently “beat the market”. His hypothesis states that asset prices reflect everything that is known at that time. In his view, it is impossible to consistently achieve outsized returns on a risk-adjusted basis since market prices already reflect all available information.

Fama’s EMH gained support from other work, such as Harry Markowitz’s modern portfolio theory (MPT) and William Sharpe’s capital asset pricing model (CAPM). In essence, CAPM assumes that everyone could simply go long and short the market at nil cost, which is clearly not the case in reality. Hence the main arguments against the CAPM, MPT and EMH stem from the fact that not everyone can do these things cost effectively. The reason, however, why everyone in the investment industry uses these concepts is that, thus far, nobody has developed anything better. It’s standard industry practice to use these concepts and assumptions feeding into each valuation model that practitioners use.

In addition, the distinction between passive and active investing is not always clear cut. For example, some nominally active funds behave passively in that their portfolios do not deviate all that much from their benchmark, and therefore their returns do not tend to deviate significantly from the latter. There is also the consideration that passive funds can be used for active investing – for example, by overweighting a particular sector in a portfolio using a passive fund that tracks the sector in question.

Logical as it all sounds, the proponents of the efficient market hypothesis are nevertheless up against considerable opposition. The very existence of investors like Warren Buffett and George Soros, who have decades-long track records of beating the market, belies the efficient market hypothesis. Buffett himself explained as much in his legendary 1984 presentation “The Superinvestors of Graham-and-Doddsville”. Further down, we’ll visit some of the scientific evidence that passive investing, despite all its strength, is not a one-fits-all solution.

Without a doubt though, passive investing has grown to be a world power. As a matter of fact, the shift to passive investing has been the standout development in the financial markets over the past decade.

How passive investing products became one of the world’s largest asset classes

Initially, investors weren’t able to follow Fama’s advice to simply hold “the market”. Replicating the market requires lots of purchases in order to make constant adjustments, which at the time would have incurred significant trading costs. Owning the entire market was not really a practicable option for investors at that point.

That hurdle was overcome in the 1970s with the introduction of the first index funds. In 1975, John “Jack” Bogle, a brilliant mathematician and Princeton graduate, founded Vanguard Group. His first fund launched with only $11.3 million in client assets. The rest, as they say, is history. Today that same index fund, now called the Vanguard 500 Index Fund, looks after client assets of $250 billion. Vanguard Group manages many other index funds, and it is now the second largest fund manager in the world (after Blackrock) with client assets totalling a staggering $7,300 billion.

The success of passive investing nowadays extends way beyond the growth of Vanguard. As of March 2020, passive funds accounted for 41 percent of the assets under management at US mutual funds and ETFs (exchange traded funds), up from 14 percent in 2005 and just three percent in 1995. Blackrock estimates that passive investors held 18 percent of all global equity at the end of 2016, a share that is likely to have increased since then.

Index funds quite simply proved a marketing success. Whereas other financial products are often too complex for consumers to understand, here was an alternative that did exactly what it said on the tin. Passive funds simply follow a given market and it’s unlikely that they will underperform their benchmark by a considerable margin. Also, these funds don’t need a team of portfolio managers and instead can largely be run by a computer. As such, they are lower cost, and often significantly so. Last but not least, passive funds are very easy to look after. For example, in contrast with active funds, there is no risk presented by the changing of the guard when a manager leaves or retires. It’s one of the ultimate buy-and-hold investments.

Indeed, as the next section shows, passive investing is probably the right approach for you, too.

The fund industry’s dirty little secrets

Our company, Sarnia Asset Management in Guernsey, is preparing to launch several funds that will pursue active investing strategies. As such, you’d probably expect us to try to convert as many investors as possible to the idea of active investing – and pour scorn on passive investing strategies.

However, our view is that for >90% of all investors, passive strategies are the way forward.

Here are not one, but two dirty little secrets of the fund management industry:

• Funds always get the most inflows towards the peak of the market and the most outflows towards the trough. The vast majority of investors always get the timing of their investments wrong. They buy high and sell low – even with investment funds! This does huge damage to their long-term performance, and they’d be a lot better off if they simply put money aside regularly and ignored the ups and downs of the market.
• Funds that have the best performance are more often than not managed by so-called “emerging managers”. These are new fund managers with relatively small amounts of client assets (usually in the hundreds of millions or single-digit billions). Due to their size, their funds are more agile. You might also find their managers work harder because they have yet to prove themselves, or they have more original thinking because they are not stuck in the kind of group think that large corporations are known to fall for.

Research has shown that investors achieve the highest performance if they:

• Use market troughs as an opportunity to up their investment in funds, rather than to pull out money.
• Invest with carefully chosen emerging managers.

But who is actually capable of doing this?

Do you have the mental fortitude not to panic during a market drop – and indeed to top-up your investments when prices are low but tensions are running high?

Do you have the skills to research and pick the best fund managers?

For most private investors, these are two challenges that are both daunting by themselves. But when taken together, they make for a truly formidable hurdle.

That’s why we believe that most investors should focus on:

• Putting aside regular savings and minimising fees by handing their savings to passive, low-cost fund managers.
• Sitting back and relaxing thereafter (and concentrating on their day-job or business to maximise their income which, in turn, maximises their savings).

However, there is a certain client group for whom active investing will be the superior and “right” product.

These experienced investors will have the resources and the expertise to locate active managers that have carved out a niche, and which are smaller and more agile than the large fund management houses. They will often look for fund managers where the owners and key staff have aligned their financial goals with those of their clients. They will also know that, contrary to popular belief, the opportunities in active investing have grown rather than diminished over recent years.

Here is some of the hard evidence as to why investors who are looking for market-beating returns need to look to active investing strategies – now more than ever before.

The case for active management

There is plenty of evidence that active investing is superior, provided it is done properly. Warren Buffett is often shown as the posterchild, but there is a lot more solid research than to simply point towards the Sage of Omaha.

A study by Invesco analysed approximately 3,000 equity mutual funds across 17 equity categories over a 20-year period to 31 December 2014, which covered five distinct market cycles. Crucially, the study only focused on what it referred to as “high active share” funds, defined as holding composition that deviated at least 60% from its underlying benchmark index. What they concluded was that truly active investing strategies have posted a history of benchmark-beating results based on excess returns, downside capture and risk-adjusted returns.

Going forward, the advantage provided by active investing might even become starker. Passive funds have done so well because the market as a whole has been performing strongly for so many years. Low interest rates and low inflation created benign market conditions for a decade but may not continue to do so. Investors must now contend with the fact that market conditions have started to change already. With inflation spiking and potentially looking stickier than first thought, stock selection may prove to be crucial when it comes to driving positive returns – both absolute and relative – in the coming years.

On top of this, the fact that the passive investing industry has grown so large is a reason for active investing as a whole to become more lucrative.

How come?

The greater the share of passive in the market, the greater the share of total market capitalisation that is effectively owned by default rather than being a conscious decision based on human research and analysis. The relative growth in passive investing has fed into a precipitous decline in analyst coverage on both sides of the Atlantic. In fact, the fall in analyst coverage is a global phenomenon, with bottom-up equity research coverage having dropped across developed, emerging and frontier markets by 20-40% in last five years.

In clear terms, individual stocks have fewer eyeballs set on them. With fewer analysts and fund managers paying attention to developments at individual companies, there will be more opportunities to find gems that the market has missed.

In Europe, this trend has been exacerbated by regulatory changes such as MiFID II. Analyst coverage of European stocks has fallen by 26% since 2011. Part of the problem stems from investment banks’ shift towards refocusing their efforts on more profitable business lines and towards their biggest and most profitable clients. MiFID II has compounded the problem in Europe by forcing asset managers to “unbundle” payment for research from trading activities. The knock-on effect is that many institutions, being faced with the prospect of paying for something that they used to receive as part of a wider service, have simply curtailed the amount of research they use. Research on Small- to Mid-cap European companies has taken a disproportionate hit. At a time when the world has become more complex and faster-moving, the research coverage of European companies has decreased rather than increased.

All this suggests there are opportunities for active investors to gain an edge. With the stock market as a whole becoming less well researched and investing decisions becoming more automated, the odds have tilted in favour of active managers.

Our team doesn’t just passionately believe in the virtues of active investing; we also have a concrete track record of practising it successfully. We haven’t been around quite as long as Messieurs Buffett and Soros, but we have been working hard to carve out our own niche and build our track record. (Also, we are not yet in our 90s and hope to have a lot further to go.)

Two of our firm’s co-founders have been managing Germany’s Paladin One fund, which has achieved a market-beating return of 95.8% over the past five years, compared to a sector average of 40.1% and 65.6% for the Euronext 100 index. What’s more, with a standard deviation of just 9.7 (number 2 out of 53 comparable funds) and a maximum drawdown (peak to trough performance) of -10% (no. 1 out of 53), Paladin One has consistently demonstrated lower volatility to both rival funds and the market indices.

Active investing is a skill that you must build up over time and which you need to demonstrate on the back of a verifiable track record. Our firm’s team has the skill and the track record. For the right kind of investor, we will soon be offering opportunities based on active investing in markets where the opportunity possibly hasn’t been greater in the past twenty years.

Professional investors will continue to choose active investing

Whilst we accept that passive funds have certainly made investing cheaper and more accessible to a raft of investors, they are also an exercise in centralisation on a gargantuan scale – and centralisation tends to come unstuck at some point along the line. We are not suggesting that passive investing is on its way out, but we do believe its portrayal as something of a panacea by some elements within the financial media and investing world is naïve and short-sighted. Passive investing is here to stay, but active investing will always be where the alpha is, as long as it’s done well. Sophisticated investors will always appreciate the benefits of active investing, and it’s this kind of investor our firm is looking to engage with.

If you’d like to discuss the themes addressed in this article in more detail, please don’t hesitate to contact us. 

Disclaimer: This blog is intended for informational purposes only. This blog is not intended to invite, induce or encourage any persons to engage in any investment activities and is not a solicitation or an offer to buy or sell any stock, investment product or other financial instruments. If in doubt, please seek financial advice from an independent financial adviser. Sarnia Asset Management is licensed by the Guernsey Financial Services Commission (GFSC). Past performance is not an indication of future returns. Investments carry risk, including the risk that you will not recover the sum that you invested.