Threadneedle thinks – February 2011 The recent global financial crisis has reopened the long-running debate concerning the merits of active versus passive funds. By moving their investments into passive funds, a number of institutional investors appear to have concluded that actively managed funds offer poor value. Times of stress inevitably bring talent into sharp focus. The financial crisis certainly underlined the difficulties faced by active managers, coupled in some cases by shortcomings in risk control. Coming as it did at the same time as significant regulatory developments in the form of UCITS III, the 2008 crisis heightened investors’ awareness of the risks of active investing. Yet despite some high profile actions, there is limited evidence of a wholesale move away from active management. Moreover, there are good reasons to believe that active management has been unfairly maligned, and that those institutions that have decided to shift assets away from active managers are missing an opportunity. The distinction between active and passive investing is not as clear as might be assumed. Some passive funds engage in practices that could be described as active in order to counter the drag on performance from management charges. At the same time, active investing covers a wide range of approaches from funds that take only minor positions against an index to completely unconstrained, high alpha portfolios. The advocates of passive investing point to the underperformance of active managers during 2008 as evidence that their beliefs are correct. But the recent stresses and gyrations in asset prices suggest that the efficient-market view of the world, the intellectual foundation of passive investing, might also require revisiting. If the efficient-market hypothesis – the philosophical basis underpinning index tracking – were correct, then the argument in favour of passive funds would be very strong. But the market is clearly inefficient and can misprice companies. As Warren Buffet has pointed out, if markets are efficient, why does he do so well by picking individual stocks? It is certainly the case that a good fund manager, supported by all the research and analytical tools deployed by an investment business, can exploit those inefficiencies. Meanwhile, passive investors are forced to hold the few large stocks and sectors that dominate market indices. This can sometimes lead to the heaviest losses, such as those generated by the banks, which weighed heavily on the FTSE 100 Index during 2008. This concentration in certain stocks and sectors can be extremely risky. Furthermore, when the index rebalances, trackers are forced to sell departing stocks at their cheapest and buy those that are entering at their most expensive. The truth, as ever, is more complicated than either side would like to admit. While passive funds might offer the advantages of transparency and cheapness, they can and do underperform the market, they clearly will never outperform significantly and their advantages in terms of risk have sometimes been overstated. Likewise, many active managers underperform or closely track the benchmark despite levying high charges. However, a number of funds consistently outperform the benchmark and there is also evidence that combining well-managed active portfolios can produce impressive risk-adjusted returns with less reliance on market beta. The evidence from the UK suggests that choosing the right active fund manager can significantly affect returns. For example, the top 10 active funds in the IMA UK All Companies sector significantly outperformed the FTSE All-Share Index over the 10 years ending November 2010, returning 128 per cent on average, compared with just 36 per cent from the index, demonstrating that more active equals more outperformance. Moreover, active fund management is part of the process by which resources are allocated efficiently in the free market. If all investors adopted the passive approach, there would be no means of differentiating between companies. Only active fund managers have the freedom to say no to a badly managed company that is seeking to raise money for a poorly thought-out acquisition. Conversely, they will discriminate in favour of a soundly managed business with a rational expansion plan. It can certainly be argued that trackers simply exploit the work carried out by active managers in this respect while making no contribution of their own. Investors will doubtless still be arguing over the merits of passive and active investing in 20 years’ time. We believe that the two styles can complement each other, with active managers using ETFs and other tracking tools to enhance their performance and/or reduce risk to the benefit of all investors. Please note: Issued by Threadneedle Asset Management Limited. Authorised and regulated by the FSA. Registered in England & Wales No 984167. Past performance is not a guide to the future. The value of investments and the income from them is not guaranteed and may fluctuate. You may not get back the amount originally invested. Changes in exchange rates may also cause the value of investments to fall or rise. For investment professional use only. Not for onward distribution to, or to be relied upon by, private investors.