In a world of passive, why be active

Whether you choose active or passive investing, the important thing is to stay invested (Photo : Capital Group)

Whether you choose active or passive investing, the important thing is to stay invested (Photo : Capital Group)

“Whether you choose active or passive investing, the important thing is to stay invested. It’s not timing the market, it’s time in the market that is critical to let things compound,” says Martyn Hole, an equities investment director at Capital Group. If you are choosing an active manager, there are certain characteristics to look for. 

In a world of passive, why be active?

In many cases people opt for passive investing because they feel they have been let down, which is particularly true for the US market. Stock markets are fairly efficient places, with lots of very smart people all trying to pick the right stocks and determine which companies to own. It’s therefore not surprising that beating the market - after fees - is difficult. The fees charged by active managers put some investor profiles off entirely.

Based on the industry returns, it is not that easy to justify active over passive. The average active manager in the US underperforms, yet that is logical. If you take the aggregate of US mutual funds and add up all of their positions, you get the market, and so after fees means you are very likely to underperform. Individual managers will differ, but together they represent the market because the mutual funds industry makes up a huge percentage of the ownership of equities. In the US, a typical portfolio manager underperforms but outperforms elsewhere such as Europe, Japan and the emerging markets. This could be due to less research on the buy or sell-side, as there is the opportunity for potential alpha from companies that aren’t widely followed.

Instead of arguing the pros and cons, we carried out extensive research and found certain specific characteristics that an investor should look for in a successful active manager:

A high level of personal investment in funds that the portfolio managers run Low fees Low turnover  Long portfolio manager tenure Manager compensation linked to long-term investment results Firm ownership through partnerships  

What does it mean to be an active manager? 

If an active manager gets 55% of their decisions right, active management is going to work well over time. Take the example of Microsoft. Sell-side research ten years ago focused on the fact that revenue growth in Windows was slowing down, even going negative, and everyone was wondering, how is Microsoft going to replace that business? Passive managers simply followed the index and missed the fundamental shift to cloud that was emerging, which led to massive outperformance of Microsoft’s shares. This kind of thing happens all the time in passive funds, whereas active managers can identify these situations of change and know how to take advantage of them. Misunderstandings over what is driving a company's profitability can provide fantastic opportunities for active managers, whereas a passive investor would track a company on the way down, and up. At one point, Amazon invested US$150 million in its mobile phone business and frequently invests similar amounts of what is essentially venture capital. While most will fail, now and again, one will work, as seen with the examples of Microsoft and Amazon’s hugely successful cloud business, which many investors were initially extremely sceptical of. The ability to recognise these opportunities is exactly how an active manager can add value.

What are the benefits of being an active manager?

Research coverage is another area where active management can demonstrate an advantage. Aside from the last 2-3 years, Japan has been in a bear market for the last 30 years. The sell-side research coverage is minimal; even large cap Japanese companies are only followed by around 15-20 analysts, and further down the market cap spectrum there are virtually no buy- or sell-side analysts at all. This provides an incredible inefficiency that can be exploited. Low coverage and no sell-side coverage in markets outside the US can provide a real opportunity.

A passive investor, by definition, must track an index, and there is a risk of becoming a slave to the index. The process whereby companies are added or removed from the index can affect stock prices in a meaningful way. Tracking an index can be inefficient, as people speculate that a particular company will be added to the index, the stock then does well, but after it’s been added to the index the shares frequently underperform. Most passive fund managers will add it the day the company enters the index. One example is Dimension Data, a South African software company that was added to the FTSE 100 on a Friday afternoon in 2000, around the time of the dotcom bubble. The previous day it closed at £6.69. On the Friday when it was added it closed at £10. On the following Monday the stock came back down to £6.68 again. Those investing in the tracker fund lost out by buying at the high point. Similarly, Tesla massively outperformed before joining the S&P 500 in December 2020 and since then has underperformed. Another aspect of passive investment is that you are tracking where the largest weights are. Just because something is big in the index, doesn’t mean it’s going to be a good investment. 

Although Capital Group is exclusively an active manager, we understand and respect the view of some investors that a balance between active and passive makes sense due to the issues we discussed earlier. But importantly, when an active manager is doing badly, which is inevitable even for the best firms, an investor mustn’t succumb to the temptation to sell out and do so at the wrong time unless something has fundamentally changed at that manager. The important point is, whether you invest actively or passively, stay invested! It’s time in the market, not timing the market that is key.

If you are interested in reading more insights from our experts, click here. If you wish to learn more about Capital Group, click here.