Curiosity, behavioural bias and a totally passive question.

I’ve always found that there’s a problem with being curious.  Sometimes you realise that what you believed to be previously correct is in actual fact absolutely wrong!

On or off over the past 6 months or so I’ve been considering the benefits of active fund management vs a totally passive approach. Within my business we still use a combination of both active and passive funds (using outsourced portfolios) however the problem is that the more I think about it, read about it and seriously think about where I add value to my clients it’s raised a few questions…

Whilst I’ve never considered myself a ‘fund picker’ however I’ve been outsourcing the responsibility of doing this to the individuals on an investment committee….whats to say this committee would do better or worse than a completely random selection or an aggregate of all the funds in a particular market sector?

Also, with the majority of fund managers in a particular sector underperforming the index (at a significantly higher cost than purchasing a passive fund) have we, for many many years, bought into a fallacy?

We’ve all been told that for many years we need fund managers.  We need “Alpha”.  We need a real person making day to day decisions to help our money grow or reduce the level of risk.

However there’s a few problems with us ‘humans’ when it comes to managing money.  We’re expensive.  We tend to be emotional when we make decisions (including investment ones) and most of the individuals actively managing money don’t seem to do any better than a computer!  Even fewer, if any at all, managed to outperform the ‘computer’ with any degree of long term consistency.

So, if the numbers tell us that the majority of active fund managers are worse (and on some occasions far worse) than a computer…shouldn’t we look at asset allocating and just automating the various assets within a portfolio using a passive vehicle?

However one issue (raised by Richard Allum on Twitter yesterday) with the passive model is that they are dependent on the market.

The market for most investment assets in the UK is, on the whole, an active market.  The majority of the decisions made aren’t made by computers. They are made by humans.

Pension Trustees, Institutional investors and individuals are all actively buying and selling assets. Whilst their decisions may be driven by a combination of both emotion and logic (with the decisions, in hindsight, being a mixed bag of good, bad and indifferent) it does generate a market due to having a wide range of individuals having different opinions about the value of a wide range of assets.  It’s one of the reasons we have markets in everything from cars to paper, oil to diamonds and shares to bonds.

If the market was entirely passive is there a risk there wouldn’t be a market at all?  Computers would all make rational decisions so with emotion taken out of the equation how would the market could work?

Alternatively would an entirely passive market  just mean that over time the market would just become incredibly efficient.  Instead of emotional decisions asset valuations would be entirely based on facts and wouldn’t be subject to the behavioural biases humans suffer from.

In my opinion it will be a long time (if ever) until we move lock, stock and barrel to passive markets.  Whilst there are economists who disagree, humans make decisions emotionally ever before they make a decision rationally…this is a good sign for the continue life of active markets!

However the issues I’m trying to get my head around (and really need your help on) are these:-

*  Could a totally passive investment market in any asset class ever exist?  If it existed could it work?  Would it be easier in one asset class than another?

*  Are there any other advantages or disadvantages to a totally passive market I haven’t considered?

*  Is the smart thing to do in a market with both active and passive funds to ‘go passive’ and let the active markets continue as it’s always done?

As ever I look forward to hearing your thoughts…

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42 thoughts on “Curiosity, behavioural bias and a totally passive question.

  • This is a topic of great interest to me. Active and passive, two sides of the same coin. Inseparable. Even though we measure returns by ratios and plot with Fibonacci the fundamentals are based on market sentiment.

    What interests me Chris is how much we involve our clients in choosing an investment strategy for their investments.

    I don’t think this debate will ever get settled. Which leads me to believe the question should be which srategy or combination would be most suitable given the client’s views,experience,risk profile and goals?

    A final thought -its interesting to me that this topic tends to polarise opinions.

    Reply
    • Hi Jenny,

      Thanks for your comment…..

      I agree that we need to think about how we communicate the difference and the risks and potential rewards of the different approached to our clients….I need to give this one far more thought!!

      However as ‘experts’ I also understand the need to be (and be perceived to be) certain….I think this is part of the reason for the polarised opinions.

      I’m coming to believe that by not entirely certain it opens the doors for a potentially better way to look at things….but maybe I’m weird!!

      Reply
  • Firstly, great post and refreshingly contrarian.

    Ok, so Im going to give you my view and I will stress the word “view”. Formula 1. I don’t really care for it and I certainly could not hold any kind of meaningful conversation on the subject. But what I do know is that the cars that race have 4 wheels (excluding the steering wheel and those 70’s nutjob motors that experimented with 6).

    I also know that tactics are employed in said motorsport and one of these is the use of different tyres. Depending on the conditions they apparently switch them around from slicks to wet? Am I getting this correct? Quick google check shows that I am getting the blunter points so thats all good.

    Why am I telling you this? Its because the active v passive debate always misses the point that active managers can be switced around. You dont need to keep hold of underperforming managers. Also, the managers themselves may not be suited to prevailing economic conditions. Furthermore, there are certain managers who I would term “all weather”; they take a more “crow flies” line through their peer sector and therefore may require less jiggerypokery on the advisers behalf.

    Now I am in no doubt that those religiously passive proponents will counter with words such as “fortune telling” and “gambling” as we have no ability to predict who will perform moving forward. Obviously. But high quality, rigerous, in depth quantitative and qualitative analysis will show you what you are looking for; be this a particualr manager who has proven over time to excell in certain conditions, or be it those managers who are “all weather”

    Also, I appreciate that this level of analysis requires considerable resource, of which many practices cannot afford or sustain. That’s cool. I also appreciate that there are many who focus upon market efficiency as opposed to inefficeinecy and therefore cost. That’s cool also. I just came here to say that you can change your wheels to suit your environment.

    And now, a 6 wheeled Formula 1 car http://is.gd/st4TJ6

    Reply
    • Thanks for your comment…a really interesting perspective.

      I don’t know enough about Formula 1 (or any driving – if you ever see me on the roads it’s worth steering clear!) to ever make a similar analogy however I’ve got a couple of issues with analogies of this type and the comparing of switching more appropriate tyres to the opportunity advisers have to switch fund managers when the conditions change.

      Let me explain….

      In Formula 1, the tyres can be switched from slicks to wet when the conditions change. The change tends to be relatively immediate and the racing teams can take virtually immediate action to make the change.

      In the world of investment management performance isn’t (and shouldn’t be) judged on immediate reactions based on a change in the environment. Most fund managers would argue that they play the long game (i hope!)

      I suppose you could argue that following ‘star’ managers would be an immediate environmental change which could motivate an immediate reaction. However I think following fund management ‘stars’ is flawed for a bunch of reasons!

      So, with Formula 1 it’s easy….the environment changes you change the tyres. With fund management it’s tougher.

      The other issue I’ve got with the analogy is proof. F1 teams know that certain tyres in certain conditions “make the car go faster”.

      The issue with active fund management is that there is no evidence that the process of high quality, in depth quantitative and qualitative analysis actually “makes the car go faster” on most occassions. On a lot of occasions (due to both charges and performance) it seems to make the car go significantly slower!

      Thanks again for your comment and adding to the debate….Also thanks for your honest! I’m still thinking deeply about this myself and your comments have provided a fresh perspective!

      Also….you gave a 6 wheeled F1 car….I give you this –

      http://retrorides.proboards.com/thread/117430

      Reply
      • Nice wheels…

        But the switching element is but one facet of my use of active management. The real driver is outperformance or the potential to achieve this.

        Let me explain… (as a wise man once said)

        Passive only users have one single chance for their risk based portfolios to outperform their peers (be this other advisers or more easily evaluated using the relavent IMA sector) and that is through asset allocation. As we all know, effective passive vehicles can only ever underperform their index and therefore the blend of these determine the clients relative successful return.

        Active management offers a second opportunity for outperformance as they have the potential to outperform their index.

        Now, as that is fact, lets move on.

        The portfolio creator/manager now has hundreds, nay thousands of managers at their disposal to populate each and every asset class and this is where it gets important for the end result. Although the potential for index outperformance is the only reason you would use active management, outperformance does not have to have equivalent levels of volatility attached to it. Good managers give more upside to equivalent downside; more bang for their buck.

        Siegel’s Paradox. Thats what it is. Protect when markets go south (through both asset allocation but most effetively using an active manager who’s skill set sits in this arena) and when the subsequent rebound occurrs your portfolio has not as far to go to get to par; its harder going uphill than down.

        Unless you apply a very tactically adjusted asset allocation, you cannot achieve that through passive’s alone. Yes, you need to pay a premium for this over and above the costs of a tracker, but I would suggest that on average a 0.5%pa premium is worth it over the longer term.

        Reply
        • Thanks Cyclopean,

          ….and I agree that Active management does offer an additional opportunity to outperform over a passive. However surely that means that the additional opportunity is also an opportunity to underperform?

          Secondly I completely get that active management provides access to thousands of different funds and fund managers and a ‘good manager’ might be able to both reduce voliatility and produce better returns.

          And that’s a good thing right? Maybe not!

          The statistics tell us that most managers don’t outperform the market and(I don’t know if there’s been any research on this) I’m wondering how effective ‘top adviser’ portfolios would be if compared to a basket of passives?

          The jump we’re taking is that the “portfolio builder” is skilled enough to build a portfolio of funds with good managers….

          The problem is that there’s no evidence that’s the case.

          Reply
  • I know I am a bit of a philistine but to me Advising is means of earning a living as opposed to an intellectual pursuit.

    I fear that if I show clients that they can use passives – ergo don’t need me – that I will struggle to justify my charges.

    Outsourcing to DFM’s has always puzzled me as my clients tend to think that I know what I am doing so how do I justify paying a third party ? And no I don’t believe that DFM’s are any better at picking funds than I am as we have access to exactly the same information.

    You might say that I can then concentrate of Financial Planning or Lifestyle stuff but I don’t know how you can get real money for that stuff year on year. Most of our clients live fairly ordinary lives which follow similar patterns and don’t need an updated cash flow spreadsheet of me every year or need me to tell them if they have not had enough holidays etc.

    I appreciate that my views don’t seem to be in accord with popular thinking and would love to hear from anyone making a good living doing things differently.

    Reply
    • Thanks Phil,

      I actually think that your practical view adds massive value to the debate.

      I’m with you on outsourcing to DFM’s but for another reason….I’m not convinced that another addition to the chain adds any value to the client on most occasions.

      However interestingly I’m not sure that it’s the fund picking element is what clients value.

      We’re entirely clear with our clients that we don’t ‘fund pick’ and they are more than happy to pay us both initial fees and a retainer….why?

      I think you’d have to ask them but they tell us that they want a human to provide them with guidance, support, explain issues and concepts and just deal with the admin side of investing!

      Now the cash flow side is a different conversation (we do provide that service to our private clients) however the point I’m trying to make is that I think as a profession we sometimes underestimate what we actually do and focus on portfolio building which potentially could be done better either adopting a passive portfolio approach or by using a built model.

      Thanks again…

      Reply
  • I think the response so far have this the wrong way round, the use of passive (I prefer low cost asset allocation) is all about risk.

    We first establish the returns clients need to achieve their objectives, so we know what returns are required – nothing to do with out performing the market – any market.

    Then we establish a diversified portfolio (for risk reduction and consistency) that stands the most chance of achieving that return. Very few clients need high returns, or to beat the market, usually inflation plus 2-3% pa will be enough.

    If you are trying, as we are, to achieve the clients goals at the lowest risk to their money this must use passive as whilst we can make assumptions and generalisations at an asset class level (and I appreciate this itself is tricky) this is impossible to do at manager level – there will always remain the chance of returns of much less than the asset class – manager risk, which is made much worse by the need to cover higher costs first.

    As an aside I do not see a time where simple passive dominates, there is too much money to be made by messing about with clients hopes – even if these means multiple types of index. Sales and purchases will still be needed as clients save or withdraw.

    Reply
    • Thanks for your response Chris….you make some interesting points.

      I agree that advisers focus should be to ensure that their clients can achieve their goals. However I think (and this is just my viewpoint) that the debate is around the best way to do this….is active, passive or a blend a better way to acheive goals?

      Reply
  • Hi Chris

    I’m afraid to say that I disagree somewhat with many of the premises that are prevalent in the investment advisory market. In no particular order:

    1) As we have no means of controlling the returns that are actually achieved by clients, isn’t determining a ‘required return to meet objective’ a bit of a spurious determination? Wouldn’t it be better to say to a client that based on their risk outlook (tolerance, capacity etc) and their goal, that assuming a conservative return, this is how much they need to be investing? The answer will probably be a much bigger number than they expect, in which case they decide to sacrifice more now or accept a more modest goal later – better returns than the assumption are a bonus to be enjoyed. This is surely all that clients care about? Let the portfolio be determined by folks paid to meet & exceed that conservative return.

    2) Passive investing is essentially about addressing only a single source of risk – underperforming an index (aka manager risk), usually one based on market capitalisation. There are smart people out there trying to create indices based on sounder investing principles than mkt cap, and funnily enough have labelled their efforts as ‘smart beta’ – what does that name tell us about mkt cap ‘beta’?

    3) Diversification of asset classes does not necessarily mean diversification of risk – the assumption of diversification lowering risk is made all too frequently, and like modern portfolio theory has been found to be disproven often enough that advisers should not take it as a given fact. The best brains in the investment industry are typically found in hedge funds, yet even there no guarantees of risks or returns should be expected.

    4) A predominantly mkt cap driven market (include closet tracking actives as well as passives) is one that should be beatable by a truly active (trader) manager that loads up on momentum stocks during periods of euphoria and by shorting stocks that have become divorced from valuation reality once the euphoria is over – difficult to achieve precision to maximise returns, but should not be too difficult to achieve some level of outperformance by objective traders.

    5) All parts of the investment chain are too expensive for the value they deliver – passives more costly than buying futures; outperformance I refer to in 4) above doesn’t usually outweigh fees; investment advisers overcharge clients with large portfolios and undercharge clients with smaller portfolios without necessarily charging on basis of the value they’re bringing – unless discretionary, we don’t manage on real time basis and there’s a seriously large hole in the levels of knowledge, experience and understanding of investing for the vast majority of financial advisers (even those with the CFA designation aren’t necessarily able to dedicate enough time and resource to adding investment value to clients to justify 0.5%-1% pa!).

    6) We, as a profession, should really be talking about clients’ ‘saving’ rather than ‘investing’ – investing should be reserved for those activities where one provides capital for a project where there are reasonably well defined return outcomes and expected project risks; most investment managers engage in ‘speculative trading’ rather than ‘investing’ and until they admit that that’s what they do, they can’t be expected to be honest about whether they actually have any trading skill or not: these are matters that are usually beyond the scope of most financial advisers to influence.

    7) My personal wish is for there to be more ‘smart beta’ and ‘hedge fund’ strategies available for the retail market, either in fund format or by way of DFMs – I suspect I have a long wait ahead, and in the mean time it’s a case of using what I consider to be the least worst for clients, and trying to be more honest with them as to where I can and can’t add value.

    Happy to have folks critique my opinions too – I’m not entitled to my own ‘facts’ either!

    Reply
    • Hi Sanjeev,

      You make some really fair points….

      You make a point in (1) where you talk about flipping the decision from not what returns we achieve but to what a client needs to save. I like this! However there’s always going to be that paid threshold when the amount approaches (or exceeds) what they can afford.

      I also agree that the ‘value chain’ is too expensive (point 5). I’m a firm believer when we work with clients we demonstrate as much value as possible….however when it comes to ‘unknowns’ like future active fund manager outperformance how can you make a judgement on how much value the chain provides?

      I like the point you made in point (7) about personal wishes. However I’ve got one concern (and this may be due to my limited mental capacity!)….complication. Do we really need new products to solve the problem or would that just complicate the issue? Would investors understand the need for ‘smart beta’ or ‘hedge fund strategies’ and would investing through them via a DFM just add another unrequired layer in the value chain.

      I also like the fact that you believe (as I do) the best we can currently do is do the best for our clients within our capacity and communicate honestly. I just think that we need to continue to ask more questions to try to challenge the status quo and understand more.

      Reply
  • Sanjeev

    In your order

    1/ Your calculation is the same as mine, return required/amount required. we are doing the same thing determining how much of a given resource is required – based on some reasonable assumptions – our assumptions may be similar. Clients need to understand what they need to do and monitor it over time as our assumptions won’t be right (but we hope will be close).

    2/ Tracking an asset class is not about market cap, it is about the best way of collecting the returns in a market at the lowest cost.

    3/ Diversification of asset classes works except at the extremes, if they are not diversified a lot of the time then they are not a different asset class. Do hedge funds do much diversification?

    4/ Market cap is one way of collecting the returns in a market, not the only way.

    5/ Removal of cost is always important, at the moment it is a big first step for the market to take. Active Managers do not add value at current fee levels, their call to take, if active was cheaper then I would look at it again.

    6/ Yes clients should spend less than they earn and save the rest. Our job to make it happen.

    7/ They are coming but will cost more, unlikely to be worth it until the cost comes down. Whilst people can still be convinced that active managers can add value cost will be too high compared to collecting the returns in the market

    Reply
    • Hi Chris B

      First of all I should apologise if you thought all my points were directed only at your comment – the “Hi Chris” I was referring to was Chris D, sorry for confusion.

      Thanks for taking trouble to comment on my comments. In response:

      2/ I agree, however the UK market has very little to offer but market cap trackers and therefore ‘market returns’ are almost always driven by market cap and creates what I might call momentum risk (I would contend that equal weights or weighting by expected cash earnings / dividends / tangible assets etc all address better the point about achieving market returns whilst addressing manager risk without creating momentum risk (I’m also unconvinced about Dimensional’s tilting and have yet to see their performance persuade me that they have an acceptable solution) – it’s the lack of choice of index that’s the problem!) – I disagree about lowest cost for market cap passives as well, as in reality Vanguard, L&G etc seek to make profits from running these funds whilst buying index futures doesn’t involve profit nor other fund costs – the FCA should really make this easier for retail clients getting advice as they can spread bet to the same lowest cost effect without advice!

      3/ I prefer to think of hedge funds as strategies as there are many different ways to skin these cats – they don’t tend to manage by way of multi- market / asset class, more by way of different sources of risk & return – hence my comment about diversification of risks. One thing that I think is not so well understood is that our typical 30-40 year views of history don’t allow for the possibility or likelihood of experiencing even more extremes within the next 30 or 40 years – we may not, but a much longer perspective on history would give a better idea of how often extremities arise and that market diversification is not always the free lunch that we’re lead to believe. Taking on or avoiding specific risks that you think are mispriced without necessarily being exposed to the markets by appropriate hedges has been demonstrated to generate returns with fewer losses to capital than traditional strategies.

      7/ I would agree that too much is spent on marketing, by both active and passive houses, to draw money in to their particular funds and not nearly enough honesty about what they’re doing so that the public can make informed decisions. I’ll give you another example of the dumb beta from market cap returns – just before it defaulted, Argentina had, by issuing lots of debt, become one of the largest constituents of the major emerging market debt indices and anybody buying a passive for that market would have had to take that exposure at precisely the time when Argentina’s credibility was approaching it’s lowest point – the indices are not constructed according to the coupons that issuers have to pay or their ability / intention to service their debts during economic downturns etc.

      We will never see passive managers saying that investors should buy futures rather than their products because of price whilst they do claim that with respect to active houses or that now is not the right time to invest in their product because valuations have become divorced from reality – in my opinion that’s no less dishonest than active managers that closet-track indices and charge fees.

      This industry really needs a more fundamental and radical change than RDR to regain the public’s trust – ideally none of us should hide now from admitting what we know & understand & what we don’t, what we really do & what we don’t, and where we add real value & where we don’t – unfortunately extremely few could meet that standard, I know I currently don’t 100% but I’m working on it!

      The age of collecting a hidden income for acting as middle-men (product providers, investment managers, active & passive, and advisers) needs to come to a faster and more conclusive end, and clients have to be sure that the industry is being honest with them if we’re to build a proper savings culture.

      Reply
    • “Active Managers do not add value at current fee levels”.

      All active managers? Sweeping statement much? Your post sings out “cost, cost, cost” without any sign of “benefit, benefit, benefit” for the client.

      Have you tried to populate your AA with actives? Or do you just disregard them totally out of hand? What benefits do you think their use will bring? Any?

      Reply
  • One thought I’ve had after posting the initial comment is regarding the areas where I believe investment managers are actually ‘investing’. I can think of the following, but I may have missed some:

    1) Infrastructure
    2) Private equity
    3) Commercial property
    4) Fixed interest

    Even in these areas ‘investing’ often becomes blurred with ‘speculative trading’ because the IMs either forget the discipline of IRRs and NPVs or are unable to sit on cash waiting for projects that carry satisfactory levels of IRR / NPV for the risks being undertaken.

    Reply
  • You know you’ve written a great blog when you generate this sort of discussion.

    Active vs. passive suffers from what I call “two sorts thinking” – it divides things into black and white with no allowance for grey, it’s very one dimensional.

    I can’t actually see that there’s any such thing as pure passive, there are just ways and degrees of passivity. When you make an asset allocation, that’s an active decision to my mind, even if there’s a passive formula for determining the components of that allocation.

    Don’t get me wrong, active managers are a bit like Harvard MBAs – in a notorious experiment, 90% reckoned themselves to be in the top 10% of their class! The average passive manager shouldn’t suffer from the delusion that (s)he’s above average nor charge you for it.

    But passives are surely guilty of a bit of physics envy. If there really were such a thing as pure passive, that sounds like a very unstable situation to me. Would they not drive asset values spiralling up, investing more in what has risen until there was no new money to invest? There could also be a downward spiral as they offload what has fallen – wouldn’t someone break ranks?

    Investing isn’t a science: there are so many variables, so many unknowns, so much beyond anyone’s control or knowledge. There’s definitely good and bad practice, though, and there are definitely risks and investments you are prepared to live with and ones you aren’t. So there’s no need to worry that active vs. passive seems to be a riddle without an answer.

    Reply
    • Thanks for your comment Andy….and your kind words on the blog. I absolutely agree with the polarisation comment.

      It seems that on this particular subject either you’re active or passive. However I think the diversity of opinion in the argument in general shows that it’s slightly more complicated than that.

      However whilst I agree with the point that investing isn’t purely a science surely we need to work harder find a commercial way to collate and analyse as much data as we can to work out the best way to invest for our clients? or is that an unrealistic aim because of the number of variables and the fact that emotion is part in the market?

      Reply
      • I’m not sure how qualified I am to answer that, Chris, but fwiw I would say it’s good (essential) to have a process that ensures you are thorough and consistent and that the process itself is efficient. However, I doubt it can ever produce “the answer”.

        We should feel glad that things like investing and retirement planning are not sciences. The fact that there isn’t a neat answer and that emotion and personal preference are involved mean we can’t easily be replaced by a computer that can “do the maths” faster. The computer can’t build a relationship and gain the client’s buy-in either. No need for “physics envy”!

        BTW, changing subject a little if I may, “the index” is a bit of a carrot in front of a donkey’s nose: indecies don’t include the costs of investing and therefore are by definition out of reach – always so to passives but only just, more so to actives except that you may occasionally snatch a bite.

        Reply
  • In the retail market there is still an in built behavioural bias towards actives – even the phrase ” passive” indicates some sort of bias. The debate is active, partly because there is a lack of relevant data. We do know some things; we know that passives are cheaper than actives. We know that most active funds under perform the market. But then there’s a long list of don’t knows. We may know that some active funds outperform their passive equivalents, but we don’t know until its too late – ie the outperformance has already taken place. We know that some fund managers are very talented and generate long term consistent out performance. But we cannot reliably predict this and we tend to support such stars when much of their out performance is already in the bag.
    We do not know much about the relative abilities of advisers to select portfolios of funds – passive or active. We may take confidence from an advisers process or experience or qualifications – but we dont know what they have done with assets they’ve advised on. So this lack of knowledge as to the relative talent of advisers applies not just to the retail investor but to the advisers themselves. So they must make the decision whether to in or out source investments without adequate knowledge of their own relative ability. Now some would say, faced with such a data gap that you must make your decision based on what you do know. That would be the risk managers approach. But maybe an alternative approach might be to consider ways to build our knowledge of relative investment acumen – any ideas?

    Reply
    • Hi Brendan,

      Thanks for your comment. I agree with many of your points. There isn’t any centralised evidence on how good advisers themselves are at picking portfolios.

      Actually It would be interesting to see whether individual advisory firms (and especially the ones which advocate adviser fund selection) would be prepared to share their stats to generate a clearer picture on the benefits (or potential disadvantages) of active fund selection.

      Your last comment makes an interesting point. However If we were to take a ‘risk management’ approach and we’re armed with the knowledge that the majority of fund managers underperform (with added costs) does this then point to a passive portfolio?

      Thanks again for your comment.

      Reply
  • I think the response so far have this the wrong way round, the use of passive (I prefer low cost asset allocation) is all about risk.

    We first establish the returns clients need to achieve their objectives, so we know what returns are required – nothing to do with out performing the market – any market.

    Then we establish a diversified portfolio (for risk reduction and consistency) that stands the most chance of achieving that return. Very few clients need high returns, or to beat the market, usually inflation plus 2-3% pa will be enough.

    If you are trying, as we are, to achieve the clients goals at the lowest risk to their money this must use passive as whilst we can make assumptions and generalisations at an asset class level (and I appreciate this itself is tricky) this is impossible to do at manager level – there will always remain the chance of returns of much less than the asset class – manager risk, which is made much worse by the need to cover higher costs first.

    As an aside I do not see a time where simple passive dominates, there is too much money to be made by messing about with clients hopes – even if these means multiple types of index. Sales and purchases will still be needed as clients save or withdraw.

    Reply
    • Thanks for your response Chris….you make some interesting points.

      I agree that advisers focus should be to ensure that their clients can achieve their goals. However I think (and this is just my viewpoint) that the debate is around the best way to do this….is active, passive or a blend a better way to acheive goals?

      Reply
  • Sanjeev

    In your order

    1/ Your calculation is the same as mine, return required/amount required. we are doing the same thing determining how much of a given resource is required – based on some reasonable assumptions – our assumptions may be similar. Clients need to understand what they need to do and monitor it over time as our assumptions won’t be right (but we hope will be close).

    2/ Tracking an asset class is not about market cap, it is about the best way of collecting the returns in a market at the lowest cost.

    3/ Diversification of asset classes works except at the extremes, if they are not diversified a lot of the time then they are not a different asset class. Do hedge funds do much diversification?

    4/ Market cap is one way of collecting the returns in a market, not the only way.

    5/ Removal of cost is always important, at the moment it is a big first step for the market to take. Active Managers do not add value at current fee levels, their call to take, if active was cheaper then I would look at it again.

    6/ Yes clients should spend less than they earn and save the rest. Our job to make it happen.

    7/ They are coming but will cost more, unlikely to be worth it until the cost comes down. Whilst people can still be convinced that active managers can add value cost will be too high compared to collecting the returns in the market

    Reply
    • Hi Chris B

      First of all I should apologise if you thought all my points were directed only at your comment – the “Hi Chris” I was referring to was Chris D, sorry for confusion.

      Thanks for taking trouble to comment on my comments. In response:

      2/ I agree, however the UK market has very little to offer but market cap trackers and therefore ‘market returns’ are almost always driven by market cap and creates what I might call momentum risk (I would contend that equal weights or weighting by expected cash earnings / dividends / tangible assets etc all address better the point about achieving market returns whilst addressing manager risk without creating momentum risk (I’m also unconvinced about Dimensional’s tilting and have yet to see their performance persuade me that they have an acceptable solution) – it’s the lack of choice of index that’s the problem!) – I disagree about lowest cost for market cap passives as well, as in reality Vanguard, L&G etc seek to make profits from running these funds whilst buying index futures doesn’t involve profit nor other fund costs – the FCA should really make this easier for retail clients getting advice as they can spread bet to the same lowest cost effect without advice!

      3/ I prefer to think of hedge funds as strategies as there are many different ways to skin these cats – they don’t tend to manage by way of multi- market / asset class, more by way of different sources of risk & return – hence my comment about diversification of risks. One thing that I think is not so well understood is that our typical 30-40 year views of history don’t allow for the possibility or likelihood of experiencing even more extremes within the next 30 or 40 years – we may not, but a much longer perspective on history would give a better idea of how often extremities arise and that market diversification is not always the free lunch that we’re lead to believe. Taking on or avoiding specific risks that you think are mispriced without necessarily being exposed to the markets by appropriate hedges has been demonstrated to generate returns with fewer losses to capital than traditional strategies.

      7/ I would agree that too much is spent on marketing, by both active and passive houses, to draw money in to their particular funds and not nearly enough honesty about what they’re doing so that the public can make informed decisions. I’ll give you another example of the dumb beta from market cap returns – just before it defaulted, Argentina had, by issuing lots of debt, become one of the largest constituents of the major emerging market debt indices and anybody buying a passive for that market would have had to take that exposure at precisely the time when Argentina’s credibility was approaching it’s lowest point – the indices are not constructed according to the coupons that issuers have to pay or their ability / intention to service their debts during economic downturns etc.

      We will never see passive managers saying that investors should buy futures rather than their products because of price whilst they do claim that with respect to active houses or that now is not the right time to invest in their product because valuations have become divorced from reality – in my opinion that’s no less dishonest than active managers that closet-track indices and charge fees.

      This industry really needs a more fundamental and radical change than RDR to regain the public’s trust – ideally none of us should hide now from admitting what we know & understand & what we don’t, what we really do & what we don’t, and where we add real value & where we don’t – unfortunately extremely few could meet that standard, I know I currently don’t 100% but I’m working on it!

      The age of collecting a hidden income for acting as middle-men (product providers, investment managers, active & passive, and advisers) needs to come to a faster and more conclusive end, and clients have to be sure that the industry is being honest with them if we’re to build a proper savings culture.

      Reply
    • “Active Managers do not add value at current fee levels”.

      All active managers? Sweeping statement much? Your post sings out “cost, cost, cost” without any sign of “benefit, benefit, benefit” for the client.

      Have you tried to populate your AA with actives? Or do you just disregard them totally out of hand? What benefits do you think their use will bring? Any?

      Reply
  • I know I am a bit of a philistine but to me Advising is means of earning a living as opposed to an intellectual pursuit.

    I fear that if I show clients that they can use passives – ergo don’t need me – that I will struggle to justify my charges.

    Outsourcing to DFM’s has always puzzled me as my clients tend to think that I know what I am doing so how do I justify paying a third party ? And no I don’t believe that DFM’s are any better at picking funds than I am as we have access to exactly the same information.

    You might say that I can then concentrate of Financial Planning or Lifestyle stuff but I don’t know how you can get real money for that stuff year on year. Most of our clients live fairly ordinary lives which follow similar patterns and don’t need an updated cash flow spreadsheet of me every year or need me to tell them if they have not had enough holidays etc.

    I appreciate that my views don’t seem to be in accord with popular thinking and would love to hear from anyone making a good living doing things differently.

    Reply
    • Thanks Phil,

      I actually think that your practical view adds massive value to the debate.

      I’m with you on outsourcing to DFM’s but for another reason….I’m not convinced that another addition to the chain adds any value to the client on most occasions.

      However interestingly I’m not sure that it’s the fund picking element is what clients value.

      We’re entirely clear with our clients that we don’t ‘fund pick’ and they are more than happy to pay us both initial fees and a retainer….why?

      I think you’d have to ask them but they tell us that they want a human to provide them with guidance, support, explain issues and concepts and just deal with the admin side of investing!

      Now the cash flow side is a different conversation (we do provide that service to our private clients) however the point I’m trying to make is that I think as a profession we sometimes underestimate what we actually do and focus on portfolio building which potentially could be done better either adopting a passive portfolio approach or by using a built model.

      Thanks again…

      Reply
  • In the retail market there is still an in built behavioural bias towards actives – even the phrase ” passive” indicates some sort of bias. The debate is active, partly because there is a lack of relevant data. We do know some things; we know that passives are cheaper than actives. We know that most active funds under perform the market. But then there’s a long list of don’t knows. We may know that some active funds outperform their passive equivalents, but we don’t know until its too late – ie the outperformance has already taken place. We know that some fund managers are very talented and generate long term consistent out performance. But we cannot reliably predict this and we tend to support such stars when much of their out performance is already in the bag.
    We do not know much about the relative abilities of advisers to select portfolios of funds – passive or active. We may take confidence from an advisers process or experience or qualifications – but we dont know what they have done with assets they’ve advised on. So this lack of knowledge as to the relative talent of advisers applies not just to the retail investor but to the advisers themselves. So they must make the decision whether to in or out source investments without adequate knowledge of their own relative ability. Now some would say, faced with such a data gap that you must make your decision based on what you do know. That would be the risk managers approach. But maybe an alternative approach might be to consider ways to build our knowledge of relative investment acumen – any ideas?

    Reply
    • Hi Brendan,

      Thanks for your comment. I agree with many of your points. There isn’t any centralised evidence on how good advisers themselves are at picking portfolios.

      Actually It would be interesting to see whether individual advisory firms (and especially the ones which advocate adviser fund selection) would be prepared to share their stats to generate a clearer picture on the benefits (or potential disadvantages) of active fund selection.

      Your last comment makes an interesting point. However If we were to take a ‘risk management’ approach and we’re armed with the knowledge that the majority of fund managers underperform (with added costs) does this then point to a passive portfolio?

      Thanks again for your comment.

      Reply
  • You know you’ve written a great blog when you generate this sort of discussion.

    Active vs. passive suffers from what I call “two sorts thinking” – it divides things into black and white with no allowance for grey, it’s very one dimensional.

    I can’t actually see that there’s any such thing as pure passive, there are just ways and degrees of passivity. When you make an asset allocation, that’s an active decision to my mind, even if there’s a passive formula for determining the components of that allocation.

    Don’t get me wrong, active managers are a bit like Harvard MBAs – in a notorious experiment, 90% reckoned themselves to be in the top 10% of their class! The average passive manager shouldn’t suffer from the delusion that (s)he’s above average nor charge you for it.

    But passives are surely guilty of a bit of physics envy. If there really were such a thing as pure passive, that sounds like a very unstable situation to me. Would they not drive asset values spiralling up, investing more in what has risen until there was no new money to invest? There could also be a downward spiral as they offload what has fallen – wouldn’t someone break ranks?

    Investing isn’t a science: there are so many variables, so many unknowns, so much beyond anyone’s control or knowledge. There’s definitely good and bad practice, though, and there are definitely risks and investments you are prepared to live with and ones you aren’t. So there’s no need to worry that active vs. passive seems to be a riddle without an answer.

    Reply
    • Thanks for your comment Andy….and your kind words on the blog. I absolutely agree with the polarisation comment.

      It seems that on this particular subject either you’re active or passive. However I think the diversity of opinion in the argument in general shows that it’s slightly more complicated than that.

      However whilst I agree with the point that investing isn’t purely a science surely we need to work harder find a commercial way to collate and analyse as much data as we can to work out the best way to invest for our clients? or is that an unrealistic aim because of the number of variables and the fact that emotion is part in the market?

      Reply
      • I’m not sure how qualified I am to answer that, Chris, but fwiw I would say it’s good (essential) to have a process that ensures you are thorough and consistent and that the process itself is efficient. However, I doubt it can ever produce “the answer”.

        We should feel glad that things like investing and retirement planning are not sciences. The fact that there isn’t a neat answer and that emotion and personal preference are involved mean we can’t easily be replaced by a computer that can “do the maths” faster. The computer can’t build a relationship and gain the client’s buy-in either. No need for “physics envy”!

        BTW, changing subject a little if I may, “the index” is a bit of a carrot in front of a donkey’s nose: indecies don’t include the costs of investing and therefore are by definition out of reach – always so to passives but only just, more so to actives except that you may occasionally snatch a bite.

        Reply
  • Firstly, great post and refreshingly contrarian.

    Ok, so Im going to give you my view and I will stress the word “view”. Formula 1. I don’t really care for it and I certainly could not hold any kind of meaningful conversation on the subject. But what I do know is that the cars that race have 4 wheels (excluding the steering wheel and those 70’s nutjob motors that experimented with 6).

    I also know that tactics are employed in said motorsport and one of these is the use of different tyres. Depending on the conditions they apparently switch them around from slicks to wet? Am I getting this correct? Quick google check shows that I am getting the blunter points so thats all good.

    Why am I telling you this? Its because the active v passive debate always misses the point that active managers can be switced around. You dont need to keep hold of underperforming managers. Also, the managers themselves may not be suited to prevailing economic conditions. Furthermore, there are certain managers who I would term “all weather”; they take a more “crow flies” line through their peer sector and therefore may require less jiggerypokery on the advisers behalf.

    Now I am in no doubt that those religiously passive proponents will counter with words such as “fortune telling” and “gambling” as we have no ability to predict who will perform moving forward. Obviously. But high quality, rigerous, in depth quantitative and qualitative analysis will show you what you are looking for; be this a particualr manager who has proven over time to excell in certain conditions, or be it those managers who are “all weather”

    Also, I appreciate that this level of analysis requires considerable resource, of which many practices cannot afford or sustain. That’s cool. I also appreciate that there are many who focus upon market efficiency as opposed to inefficeinecy and therefore cost. That’s cool also. I just came here to say that you can change your wheels to suit your environment.

    And now, a 6 wheeled Formula 1 car http://is.gd/st4TJ6

    Reply
    • Thanks for your comment…a really interesting perspective.

      I don’t know enough about Formula 1 (or any driving – if you ever see me on the roads it’s worth steering clear!) to ever make a similar analogy however I’ve got a couple of issues with analogies of this type and the comparing of switching more appropriate tyres to the opportunity advisers have to switch fund managers when the conditions change.

      Let me explain….

      In Formula 1, the tyres can be switched from slicks to wet when the conditions change. The change tends to be relatively immediate and the racing teams can take virtually immediate action to make the change.

      In the world of investment management performance isn’t (and shouldn’t be) judged on immediate reactions based on a change in the environment. Most fund managers would argue that they play the long game (i hope!)

      I suppose you could argue that following ‘star’ managers would be an immediate environmental change which could motivate an immediate reaction. However I think following fund management ‘stars’ is flawed for a bunch of reasons!

      So, with Formula 1 it’s easy….the environment changes you change the tyres. With fund management it’s tougher.

      The other issue I’ve got with the analogy is proof. F1 teams know that certain tyres in certain conditions “make the car go faster”.

      The issue with active fund management is that there is no evidence that the process of high quality, in depth quantitative and qualitative analysis actually “makes the car go faster” on most occassions. On a lot of occasions (due to both charges and performance) it seems to make the car go significantly slower!

      Thanks again for your comment and adding to the debate….Also thanks for your honest! I’m still thinking deeply about this myself and your comments have provided a fresh perspective!

      Also….you gave a 6 wheeled F1 car….I give you this –

      http://retrorides.proboards.com/thread/117430

      Reply
      • Nice wheels…

        But the switching element is but one facet of my use of active management. The real driver is outperformance or the potential to achieve this.

        Let me explain… (as a wise man once said)

        Passive only users have one single chance for their risk based portfolios to outperform their peers (be this other advisers or more easily evaluated using the relavent IMA sector) and that is through asset allocation. As we all know, effective passive vehicles can only ever underperform their index and therefore the blend of these determine the clients relative successful return.

        Active management offers a second opportunity for outperformance as they have the potential to outperform their index.

        Now, as that is fact, lets move on.

        The portfolio creator/manager now has hundreds, nay thousands of managers at their disposal to populate each and every asset class and this is where it gets important for the end result. Although the potential for index outperformance is the only reason you would use active management, outperformance does not have to have equivalent levels of volatility attached to it. Good managers give more upside to equivalent downside; more bang for their buck.

        Siegel’s Paradox. Thats what it is. Protect when markets go south (through both asset allocation but most effetively using an active manager who’s skill set sits in this arena) and when the subsequent rebound occurrs your portfolio has not as far to go to get to par; its harder going uphill than down.

        Unless you apply a very tactically adjusted asset allocation, you cannot achieve that through passive’s alone. Yes, you need to pay a premium for this over and above the costs of a tracker, but I would suggest that on average a 0.5%pa premium is worth it over the longer term.

        Reply
        • Thanks Cyclopean,

          ….and I agree that Active management does offer an additional opportunity to outperform over a passive. However surely that means that the additional opportunity is also an opportunity to underperform?

          Secondly I completely get that active management provides access to thousands of different funds and fund managers and a ‘good manager’ might be able to both reduce voliatility and produce better returns.

          And that’s a good thing right? Maybe not!

          The statistics tell us that most managers don’t outperform the market and(I don’t know if there’s been any research on this) I’m wondering how effective ‘top adviser’ portfolios would be if compared to a basket of passives?

          The jump we’re taking is that the “portfolio builder” is skilled enough to build a portfolio of funds with good managers….

          The problem is that there’s no evidence that’s the case.

          Reply
  • Hi Chris

    I’m afraid to say that I disagree somewhat with many of the premises that are prevalent in the investment advisory market. In no particular order:

    1) As we have no means of controlling the returns that are actually achieved by clients, isn’t determining a ‘required return to meet objective’ a bit of a spurious determination? Wouldn’t it be better to say to a client that based on their risk outlook (tolerance, capacity etc) and their goal, that assuming a conservative return, this is how much they need to be investing? The answer will probably be a much bigger number than they expect, in which case they decide to sacrifice more now or accept a more modest goal later – better returns than the assumption are a bonus to be enjoyed. This is surely all that clients care about? Let the portfolio be determined by folks paid to meet & exceed that conservative return.

    2) Passive investing is essentially about addressing only a single source of risk – underperforming an index (aka manager risk), usually one based on market capitalisation. There are smart people out there trying to create indices based on sounder investing principles than mkt cap, and funnily enough have labelled their efforts as ‘smart beta’ – what does that name tell us about mkt cap ‘beta’?

    3) Diversification of asset classes does not necessarily mean diversification of risk – the assumption of diversification lowering risk is made all too frequently, and like modern portfolio theory has been found to be disproven often enough that advisers should not take it as a given fact. The best brains in the investment industry are typically found in hedge funds, yet even there no guarantees of risks or returns should be expected.

    4) A predominantly mkt cap driven market (include closet tracking actives as well as passives) is one that should be beatable by a truly active (trader) manager that loads up on momentum stocks during periods of euphoria and by shorting stocks that have become divorced from valuation reality once the euphoria is over – difficult to achieve precision to maximise returns, but should not be too difficult to achieve some level of outperformance by objective traders.

    5) All parts of the investment chain are too expensive for the value they deliver – passives more costly than buying futures; outperformance I refer to in 4) above doesn’t usually outweigh fees; investment advisers overcharge clients with large portfolios and undercharge clients with smaller portfolios without necessarily charging on basis of the value they’re bringing – unless discretionary, we don’t manage on real time basis and there’s a seriously large hole in the levels of knowledge, experience and understanding of investing for the vast majority of financial advisers (even those with the CFA designation aren’t necessarily able to dedicate enough time and resource to adding investment value to clients to justify 0.5%-1% pa!).

    6) We, as a profession, should really be talking about clients’ ‘saving’ rather than ‘investing’ – investing should be reserved for those activities where one provides capital for a project where there are reasonably well defined return outcomes and expected project risks; most investment managers engage in ‘speculative trading’ rather than ‘investing’ and until they admit that that’s what they do, they can’t be expected to be honest about whether they actually have any trading skill or not: these are matters that are usually beyond the scope of most financial advisers to influence.

    7) My personal wish is for there to be more ‘smart beta’ and ‘hedge fund’ strategies available for the retail market, either in fund format or by way of DFMs – I suspect I have a long wait ahead, and in the mean time it’s a case of using what I consider to be the least worst for clients, and trying to be more honest with them as to where I can and can’t add value.

    Happy to have folks critique my opinions too – I’m not entitled to my own ‘facts’ either!

    Reply
    • Hi Sanjeev,

      You make some really fair points….

      You make a point in (1) where you talk about flipping the decision from not what returns we achieve but to what a client needs to save. I like this! However there’s always going to be that paid threshold when the amount approaches (or exceeds) what they can afford.

      I also agree that the ‘value chain’ is too expensive (point 5). I’m a firm believer when we work with clients we demonstrate as much value as possible….however when it comes to ‘unknowns’ like future active fund manager outperformance how can you make a judgement on how much value the chain provides?

      I like the point you made in point (7) about personal wishes. However I’ve got one concern (and this may be due to my limited mental capacity!)….complication. Do we really need new products to solve the problem or would that just complicate the issue? Would investors understand the need for ‘smart beta’ or ‘hedge fund strategies’ and would investing through them via a DFM just add another unrequired layer in the value chain.

      I also like the fact that you believe (as I do) the best we can currently do is do the best for our clients within our capacity and communicate honestly. I just think that we need to continue to ask more questions to try to challenge the status quo and understand more.

      Reply
  • One thought I’ve had after posting the initial comment is regarding the areas where I believe investment managers are actually ‘investing’. I can think of the following, but I may have missed some:

    1) Infrastructure
    2) Private equity
    3) Commercial property
    4) Fixed interest

    Even in these areas ‘investing’ often becomes blurred with ‘speculative trading’ because the IMs either forget the discipline of IRRs and NPVs or are unable to sit on cash waiting for projects that carry satisfactory levels of IRR / NPV for the risks being undertaken.

    Reply
  • This is a topic of great interest to me. Active and passive, two sides of the same coin. Inseparable. Even though we measure returns by ratios and plot with Fibonacci the fundamentals are based on market sentiment.

    What interests me Chris is how much we involve our clients in choosing an investment strategy for their investments.

    I don’t think this debate will ever get settled. Which leads me to believe the question should be which srategy or combination would be most suitable given the client’s views,experience,risk profile and goals?

    A final thought -its interesting to me that this topic tends to polarise opinions.

    Reply
    • Hi Jenny,

      Thanks for your comment…..

      I agree that we need to think about how we communicate the difference and the risks and potential rewards of the different approached to our clients….I need to give this one far more thought!!

      However as ‘experts’ I also understand the need to be (and be perceived to be) certain….I think this is part of the reason for the polarised opinions.

      I’m coming to believe that by not entirely certain it opens the doors for a potentially better way to look at things….but maybe I’m weird!!

      Reply

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