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Monkeys move in on the active vs. passive debate

April 12, 2013
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Those, like us, who’ve been watching the active versus passive investing debate unfold online these past few months will have noticed two very definite trends.

First, the advantages of passive and the drawbacks with active are being talked about far more often, especially here in the UK. We like to think that we at Sensible Investing have played a part in that; the fact that our videos have been viewed 30,000 times in the last month certainly suggests that we have. 

The second, and more recent, development we’ve noticed is that those who favour active fund management (often, it must be said, people with a vested interest in its remaining the default style of investing) are starting to make their voices heard as well. 

In fact we welcome the second trend just as much as the first, and yes, we hope we’ve contributed to that one as well. One of the most frustrating things for proponents of passive over the years has been the reluctance of the investment industry to engage with us in meaningful debate. That, thank goodness, is beginning to change. 

An example of this was the zeal with which the activistas, if we can call them that, seized on recent research by Cass Business School, which queried the wisdom of an index based on market capitalisation, which the majority of passive funds tend to be. The report suggested that, over the last 40 years, US equity indices constructed randomly by computers (or indeed by monkeys) would have produced higher risk-adjusted returns than an equivalent cap-weighted index. 

The report’s authors argued that indices which weight stocks by something other than market capitalisation - dividends, total asset value, or annual cash flows, for example - are more likely to deliver higher returns. This approach, sometimes known as “smart beta”, is in fact becoming increasingly popular. 

The research was picked up on in an article by the highly respected MoneyWeek commentator Merryn Somerset Webb, in an article with the eyecatching headline Why traditional passive investing doesn’t work, which was duly retweeted several thousand times by those in the active camp. 

As it happens we don’t have an issue at all with the Cass findings. We certainly wouldn’t argue that the cap-weighted index is perfect, only that, weighing up the relative costs and expected returns, it provides much better value for the consumer than actively managed alternatives. 

That’s because the so-called experts, as study after study has shown, are little better than monkeys at picking stocks themselves. More importantly, while monkeys would presumably do it for free or, at most, a few bananas, the professionals exact a hefty fee which, over the course of an investing lifetime, can leave a sizeable hole in the value of your investments. 

Yes, there are other ways of compiling an index, and indeed we plan to investigate smart beta, and the exciting research being conducted in this area, in future videos. 

What the research emphatically doesn’t do, however, is to let the active fund management industry off the hook. Thanks largely to the Internet, investors have started seeing through its multi-billion-pound advertising. We’re increasingly turning away from high-cost, poorly performing active funds towards low-cost and highly diversifed passive portfolios. Index-based investing is the future. Precisely which markets those indices track, and how they’re weighted, will be down to personal choice. 

Merryn Somerset Webb herself has often pointed out the failure of active managers to outperform the market consistently, and their lack of transparency on charges. And, as Professor Steve Thomas, one of the authors of the Cass report told us himself in our documentary, Passive Investing: The Evidence, charges are “one of the main determinants of long-term wealth destruction”.

 One final point on the Cass research worth noting is that Professor Thomas and his colleague Professor Andrew Clare, another of the report’s authors, are also the brains behind a recently-launched smart beta fund. Just thought we’d mention it.

Image: Robin 24/Flickr


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