Will an actively managed investment fund outperform its passive counterparts? Otago University’s David Lont says it’s hard to beat the monkey.

Princeton University professor Burton Malkiel famously wrote that a blind-folded monkey throwing darts at a newspaper’s financial pages would outperform stocks picked by experts.

It’s an interesting proposition and one that obviously ruffles the feathers of financial advisers who dominate the market by making a living from using their skills and knowledge to provide good returns to paying customers. At the other extreme, passively managed funds, cutting out the active manager and their intelligence, but also their fees are now about 30 percent of the US market.

Kiwi Wealth’s whitepaper reignited the debate recently claiming “both academic and industry researchers conclude, that the balance has tipped with active management beating passive benchmarks on average.”

While it’s not as simple as passive versus active, the case for passive funds is strong for most investors.  

S & P’s SPIVA U.S. Scorecard offers insights into the two systems. In a 2017 report, they showed that the longer the investment horizons, the less likely it is that an active manager beats the benchmark after fees – so a well-diversified, passive fund is a better option for most. Their Australia report is more promising, but even so, it is best a coin toss in the mid and small cap funds as to whether a manager will outperform over 15 years.

Many fund managers are overconfident and the public buy the illusion. When a fund touts its performance, the fine print states that past performance does not guarantee future performance. That is good advice as the evidence suggests outperformance does not continue.

Some supporters of active management argue active managers shine during volatile periods. Well, 2018 was a volatile year. S & P reports “Amid the market volatility, 2018 was the fourth-worst year for U.S. equity managers since 2001; 68.83 percent of domestic equity funds lagged the S&P Composite 1500.”

There are talented mangers but this is their intellectual capital, so most charge a performance fee. However, as Nobel Laureate William Sharpe argues, for every buyer there is a seller, and so en masse no one can win. At best it is a zero sum gain. Add in fees and it becomes negative.

The array of evidence can be confusing. Kiwi Wealth highlights research that shows size and value factors can achieve higher returns but since you can replicate such a strategy by buying cheap exchange-traded funds (ETFS), it is not a case for high management fees.
Kiwi Wealth also quotes two Yale professors, Cremers and Petajisto (2009) whose work suggests that the degree of active trading can be a good indicator of superior returns. Subsequent work, including one using the same data and results conclude that the active share metric is not useful for predicting performance.

Warren Buffett is a well-known proponent of value investing. Even if Warren Buffett is a star performer, how long can it continue? Would other fund managers be able or want to replicate his strategy?

Not everyone is Warren Buffett and fund managers come and go with relative frequency, about half over a 15-year period according to S & P.

Should you even consider active management? Yes, if your tolerance for this sort of active risk allows it, but it should be limited. Yes, if it is the only option offered in a corporate retirement savings scheme that comes with a match too attractive to ignore.

However history shows that if you are well diversified, keep costs as low as possible, and save early (start young) and often, then time in the market will typically beat timing the market.

Every investment has a cost, but active funds charge more than passive funds and these fees add up. Imagine you have $100,000 to invest. If you earned 6 percent a year for the next 20 years and had no costs or fees, you end up with about $321,000. However, if you have to pay 1 percent in fees per year, you end up with about only $265,000.

Why pay fees of 1-2 percent of assets per year when some ETFS charge as little as five basis points, without some advantage to you?

Picking low fee funds is good advice but determining all the costs can be hard. Your time, compliance, tax issues, trading and hedging costs, entry and exit fees add to the complexity.

Like any issue, things are not black and white. New technology, big data, cheap access to quality research and robo-advisors are disrupting the industry and the evidence. While plenty of studies have shown various market anomalies, including some of my own, the real question is: can we make money from them? Many opportunities are short lived because barriers to entry are low in competitive capital markets.

Our Small Market
New Zealand’s small market means our investment choices are more limited than in the US, UK and even Australia but things are much better than 20 years ago.

Access to ETFS from global leaders such as Blackrock and Vanguard, via NZX Smartshares is progress but the fees charged here are significantly higher than in the US.

Too much choice might create its own problems. You need scale to keep fees down so small KiwiSaver funds and ETFS will struggle in a more competitive environment. Globally there are more than 5000 ETFS allowing you to tilt your portfolio to a favoured investment approach, ESG (social and environmental), value, growth, dividend yield or growth, US or global, small, mid, large cap bias, emerging, country or sector specific, etc. Any one of these is an active choice on your part. What is your competitive advantage?

Looking ahead, the drive to lower fees will continue. Some US brokers have stopped charging for trading shares. Lower cost competitors are appearing in New Zealand (Smartshares, Hatch, Simplicity, Sharesies are examples) causing active managers to assess and justify their fees.

It is hard to beat the monkey. If you agree, work out your risk profile and tolerance, diversify accordingly, keep your fees as low as possible, invest for the long term and stick to your savings plan. Don’t panic when markets show a downturn as time in the market and low fees are more associated with good outcomes than is timing.  

A good adviser can help you avoid the pitfalls and that can be valuable. The value they add may be solely in helping you to form a passive low cost-plan, and counselling you when markets are volatile. However, do not expect most to add value by directing you to funds that consistently outperform the market.

These are the opinion of the author. As such, they should not be construed as investment advice.

Professor David Lont is from the University of Otago's Department of Accountancy and Finance.

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