Active vs Passive

A new report from BMO Global Asset Management has issued a major challenge to the assumption that passive funds always outperform the average active manager.

  • The number of passive funds has grown by 817% over the past 20 years
  • The average active fund has outperformed the average passive fund in the UK, Europe and Japan
  • The BMO GAM multi-manager team is currently running with its lowest-ever exposure to passives, at between 13%-16%

The assumption of active underperformance has underpinned much of the move to passive over the past few years. The argument in favour of passive is usually that given the average active manager underperforms and it is hard to find the above-active manager, why bother looking?

The passive industry has grown exponentially: in 1998 there were 47 passive funds across the seven Lipper sectors reviewed by the BMO team. This had risen 817% to 431 by the end of 2018.

The research is part of BMO GAM's PassiveWatch. It reviewed the 20-year performance of all active and passive funds across the UK, Europe, Asia, US and Japan. It found that the average active fund outperformed the average passive fund in the UK, Europe and Japan. Even in the US, where passive funds outperformed on average, the best-performing active fund delivered 6.3x the return of the average passive fund.

The report amply demonstrated the need to be selective among active funds. Among emerging markets funds, there was a gap of 24.7% between the best and worst performing funds. This compared to just 2.6% seen in the European sector.

The BMO GAM multi-manager team is currently running with its lowest-ever exposure to passives, at between 13%-16%. While they can bring down fees, they inevitably underperform the index they are designed to track due to fees and tracking error.

There is also the question of whether now is likely to be a better time for active managers. Passives have been in a sweet spot: the large cap stocks that form the largest part of most indices have done well. This is particularly true in the US, where the large global technology companies have continued to get stronger, and in the UK, where large caps have benefited from the weakness of sterling in the wake of the Brexit vote.

UK mid-caps have underperformed, largely because of their greater exposure to the domestic economy. However, relative valuations now look compelling compared to history. This is a favoured stomping ground of the active manager and any improvement in the mid-cap arena might also improve the dynamic between active over passive.

The report also warned on using passives for corporate bonds: "In the period of ultra-low interest rates post the credit crisis of 2008, companies have (understandably) used this opportunity to issue debt. Some of this debt has been deployed as a productive use of capital but in other cases, cheap debt has been issued to finance share buy backs… We also have concerns around corporate bond liquidity and feel that an active manager would be better placed to weather any potential volatility."

The active versus passive debate is slowly seeing a welcome recalibration. Both sides have a role in a balanced portfolio.

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