This is the question: is active funds management worth the effort?
As far back as 1609 William Shakespeare was mulling over the active/passive conundrum in one of the most famous passages from his Netflix mini-series, ‘Hamlet’ (working title: ‘CSI Copenhagen’).
“Whether ’tis nobler in the mind to suffer
The slings and arrows of outrageous fortune,” the procrastinating Danish protagonist whined.
“Or to take arms against a sea of troubles.”
Often misinterpreted as a contemplation on mortality, Hamlet’s speech was actually a query posed to the Danish Investment Consultant Royal on whether to invest the Crown’s substantial treasury holdings in an index fund or adopt a more active strategy.
More than 400 years since Hamlet fronted his investment committee the debate between proponents of active and passive managed fund styles continues to rage.
But while the choice between active and passive investing is usually presented in either/or format, the reality is rather more nuanced.
Most active fund managers, for instance, would acknowledge that investing-by-the-index can be a useful way to gain exposure to the market. Likewise, the most passionate passive investors usually admit that some indexes are easier to beat than others.
For instance, it is a little-known fact that even Vanguard – the largest passive investment manager in the world (and available on InvestNow) with more than US$4.2 trillion under management – has a large active funds division.
Confusingly for investors, both active and passive managers can point to numerous academic studies supporting their respective causes.
However, there is a growing, if tentative, consensus that index-investing works best in large, liquid, well-researched markets while active management earns its keep more easily where information is harder to come by.
It is important to note that the ‘median’ manager result cited in many reports includes a whole swag of small funds rather than the products investors actually use.
For instance, in its online database, fund research house Morningstar includes a grand total of 681 New Zealand funds with just on $36.8 billion under management, of which 50 per cent is invested in the 30 largest funds.
Investors weighing up the costs and benefits of active and passive management, then, must carefully consider the characteristics of the underlying asset classes they plan to invest in, as opposed to relying only on rigidly-held philosophical beliefs.
Why bonds and benchmarks don’t mix well
The majority of publicity surrounding index-investing tends to focus on equities – typically the US share market – for proof of concept. And there is evidence showing that over the long-term the average active manager investing in the biggest US companies struggles to beat the index after fees.
For instance, a recent study by the world’s biggest bond manager, PIMCO, found just 43 per cent of active US equity managed funds outperformed their active peers after fees.
But the PIMCO analysis found more than half of US active fixed income funds beat the average passive counterpart manager after fees across all time periods it measured (from one to 10 years) “with 63 per cent of them outperforming over the past five years”.
Similar results crop up in the NZ fixed income market where research by consulting firm Melville Jessup Weaver (MJW) shows that the median NZ bond manager outperformed the index by 0.7 per cent over the 10 years to June 30 2016.
Bonds, as PIMCO says, “are different”.
“Bond investors have varying objectives, which is seldom the case for equities,” PIMCO says. “Trading dynamics differ. New issues, and their magnitude within benchmarks, are more significant factors. And the return profile of individual bonds is far more skewed than it is for equities.”
The median NZ shares manager: better than average
Interestingly, the ‘median’ equity manager also has traditionally held the edge in the NZ share market. According to a February 2017 report by Mercer, the median NZ share manager has beat the index after fees “over all periods” in the study.
Andrew Bascand, head of Wellington-based Harbour Asset Management, says investors should expect active managers “to be truly active – not just taking small tilts around an index or benchmark”.
“Too many active managers have a low underlying active share or deviation from the benchmark,” Bascand says. “Fees need to reflect the real potential added value from the fund manager.”
Mark Brighouse, Fisher Funds’ Chief Investment Officer, like Harbour also an InvestNow option says that “passive management is saying that there is no value on having knowledge and understanding of an investment and I will never be convinced that it is a better long term approach.”
Brighouse continues “Fisher Funds has been managing active funds for nearly 20 years and our oldest fund has beaten the index, after fees, by around 1-2 per year on average, if you look at cumulative performance over the years the fund has been in operation. It’s true that not all active funds have done as well and that’s why it is important to understand a manager’s strategy.”
Like Bascand, Mark Brighouse acknowledges that in some instances indexing makes sense: “You’d have to be silly not to appreciate a fund with cheaper fees than an active fund, delivering the same returns as the broad market.”
How fees follow flows
Undoubtedly, the huge flows of money globally into passive funds in recent years – helped in part by the rapid rise of the exchange-traded fund (ETF) sector – has put pressure on active managers to justify their fees.
At the same time, passive fund fees are also – or should be – dropping as scale builds. Ultimately, index funds must compete on fees, not underlying investment skill. That is why InvestNow is committed to offering lowest-price passive options to members who prefer the index-investing approach: for example, the 0.2 per cent annual fee on the Vanguard International Shares Select Exclusions Index Fund, via InvestNow, is the cheapest available for NZ retail investors.
Unlike Hamlet, fund investors, of course, needn’t choose to be, or not to be, active or passive: they can be both.
That is the answer.
Key insights about the NZ investment industry
InvestNow offers both active and passive index funds, reflecting that both play legitimate roles in investors’ portfolios.
New Zealand’s tax rules for NZ and global share PIE funds result in the gains made from active management being tax free, while management fees are tax deductible. This is unique tax treatment provides a tailwind for active management – which we don’t believe exists elsewhere in the world.
The MJW Investment Survey provides return data for the major funds available in the NZ market. For the 10 years to 31 March 2017, investment managers have added value on a gross of fees and tax basis in New Zealand shares, global shares, listed NZ property, NZ bonds and global bonds. Clearly the level of fees paid for active management is an important factor that needs to be considered by investors.
At InvestNow we are committed to providing both active and passive funds so that you, the client, can select which is the best fit for your portfolio.