The potential for passive

In the ongoing debate between active and passive index matching, passive strategies appear to have the advantage.

The latest analysis of global fund flows predicts that in the next few years, assets invested in passive strategies could overtake those in active funds in the US.

In fact the latest analysis of global fund flows predicts that in the next few years, assets invested in passive strategies could overtake those in active funds in the US. Given the outlook globally, a similar theme could soon occur in other developed markets.

Active management has somewhat been a victim of its own success, with index funds increasingly competitive performance being somewhat attributable to the huge surge in financial professionals over the last half a century.

We have conducted our own investigation to understand two questions;

  1. Have active managers underperformed their benchmarks?
  2. Is the likelihood of outperformance limited to particular areas of the global market?

We have compiled a database of around 4,500 active equity funds available for sale across Europe which have a track record back to at least the beginning of 2010, and categorised them across 25 varied sectors. By capturing data since 2010 we avoid the anomalies following the global financial crisis as well as capturing the period in which passive strategies have largely proliferated.

To justify fees, an active manager should be considered 'successful' if they are able to deliver at least one, or ideally, a combination of the below;

  1. Better returns than the index after fees
  2. A positive risk adjusted return (in terms of Alpha) – meaning a more efficient allocation of risk than the market
  3. A lower level of risk – to deliver an element of downside protection

For each of these measures, we judge success as being able to produce both;

  • A superior result over the entire seven year period since the beginning of 2010 and,
  • A better result in at least four of the individual seven calendar years from 2010 to 2016

By achieving the above, the manager will have produced both a superior result over time, and given the investor a realistic chance of capturing this by delivering some level of consistency. The following chart displays the percentage of active funds within each of the underlying sectors which have delivered on the above measures of success.

Initially, looking at which funds have returned in excess of their indices, the landscape seems bleak for active investors, only four of the 25 sectors have more outperforming managers than underperforming (marked with a 50% threshold in red) and only eight sectors have a third of funds outperforming the indices (marked with a 33% threshold in black). To compound the problem, the most opportune areas for active managers are those which typically represent very small allocations of global benchmarks, such as regional small cap funds as well as smaller, regional emerging markets such as Indian, Latin American and emerging European equities. An area of optimism however, is within UK and UK Equity Income funds which have a strong history of active managers being able to outperform.

The result on a risk-adjusted return basis differs only marginally, but the trend does improve slightly in favour of the active managers. However, in the main, the larger allocations of the global equity market such as the US, Japan, global emerging market and broad global equity funds have less than a third of managers being measured as successful. This does support the common belief that the more developed equity markets are more efficient at pricing assets and therefore it's more difficult for active managers to outperform the index.

Architas bar chart 1

Finally we look at risk. Should an active manager fail to provide improved returns, they should at least consistently provide an alternative strategy which can provide lower risk than the market, potentially offering some element of downside protection. Results improve slightly but in-line with the previous trends, the best sectors lie in the smaller, more esoteric, less well researched areas such as emerging markets, small cap and to a degree, more specialist areas of property and precious metal funds.

Architas bar chart 2

It is clear that a level of expertise is needed to select active managers which have the potential to outperform in a simple return sense. Despite the odds being skewed against us, we still employ a US equity sector specialist and we still believe we are able to find managers that can outperform in that sector and all others too.

But given the above evidence, passive strategies would seem an opportune means to gain market levels of performance whilst seeking to limit underperformance by benefitting from scale to reduce fees. Our role is to try and use the risk budget we have for each of our passive portfolios and allocate as efficiently as possible between the different regions to deliver the best possible risk adjusted returns. As well as select and ensure that each passively managed underlying fund matches its risk and return characteristics as closely as possible and in the most cost-effective way.

For further market insight please visit www.adviserpointsofview.com For more information, call us on 020 7562 4900; Monday to Friday 9.00am – 5.00pm, calls may be recorded, or visit architas.com

This is for professional clients only and should not be distributed to, or relied upon by, retail clients. Past performance is not a guide to future performance. The value of investments and any income from them can go down as well as up and is not guaranteed. Your clients could get back less than they originally invested. The views expressed within this article are those of Architas, who may or may not have acted upon them.