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Friday
Apr222011

Active versus passive: Two misleading arguments

When fund managers state their views on this debate, we can hardly blame them for bias towards their own type of management.  However both sides tend to use arguments that don’t stand up to close scrutiny. 

Argument 1 (used by active managers): 

“When markets fall, passive funds fall with the market, but active managers can save you from some of the downside.”

The first part of this argument is obviously true.  If the market falls by 10% a passive fund tracking that market will also fall by 10% (give or take a small tracking error).

However, the second part of this is disingenuous.

The return you will get on an actively managed fund will definitely be:

{The return on the benchmark}

LESS

{The fees charged by the manager}

PLUS or MINUS

{The value of the “bets” the fund manager takes on your behalf}

If the market falls by 10%, you will suffer this loss regardless of whether you have invested passively or actively.

On top of that you will get the value of the fund manager’s “bets”.  This might offset some of the loss, or it might exacerbate the loss.  Unless the manager has a systematic bias, the manager’s ability to outperform should not be affected by whether the market goes up, down or sideways.

By comparison, the return on a passive fund will definitely be:

{The return on the benchmark}

LESS

{The fees charged by the manager}

PLUS or MINUS

{The value of the tracking error between the fund and the benchmark}

For credible passive managers, in most cases the last part, the tracking error, will be negligible.  So from an expected return perspective, active versus passive becomes a simple equation.

If you can find a fund manager that you believe the value of the “bets” that they will take on your behalf is likely to be greater than the difference between their fees and the passive equivalent, then that fund manager will be better from a long-term return perspective.

If it is less, then go for the passive alternative.

Whether you think the market is going up, down or sideways is irrelevant to this decision.

Argument 2 (used by passive managers): 

“Passive funds are less risky than active funds.”

This is another disingenuous argument.  In most cases, the additional risk from investing in actively managed funds is negligible.

“Tracking error” is a measure of risk.  It gives an indication of the likely out- or under- performance of an investment against a particular benchmark. 

For example a passive fund might have a tracking error of 0.25%pa, which means that you can expect that fund to be within 0.25% of the index return two years out of three.  So if the market fell by 10%, we could reasonably expect the return on the fund to be between -10.25% and -9.75%.  There is still a one-in-three chance that the return might be worse than -10.25% or better than -9.75%.

By comparison, an active fund might have a tracking error of 4%pa.  In which case, if the market fell by 10% we would expect the fund’s performance to be between -14% and -6% with a two-thirds probability. (So there’s a one-in-three chance that the performance would be either worse than -14% or better than -6%.)

At first glance this seems to back up the passive managers’ argument.  An active fund with a 4%pa tracking error is 16 times “riskier” than a passive equivalent with a 0.25%pa tracking error.

However, that misses the point.  Whether a fund out- or under- performs the index is not a relevant measure of risk for most pension schemes.  What is more important is how the assets fare compared to the liabilities.  A return of 20% would be disastrous if the liabilities rose by 40% over the same period; conversely -10% on the assets would be fine if the liabilities had fallen in value by 20%.

In the same way we estimated a tracking error for funds against their respective benchmarks, we can estimate a tracking error for the assets against the liabilities.  For example, if a scheme that was 100% funded at the start of the year had a tracking error of 15%pa against the liabilities, and contributions exactly kept pace with the accrual of new liabilities, then we would expect the funding position at the end of the year to be between 85% and 115% (with a two-thirds probability).

Most of this risk comes from the strategic asset allocation rather than the choice of manager 

In our experience, a “tracking error” from the asset allocation of 10%pa would be at the low end – certainly a reasonably conservative strategy for a typical UK pension scheme. 

Conversely a “tracking error” from active management of 4% across the whole scheme would be on the aggressive end (When you combine active funds the overall level of risk decreases due to diversification).

So if a conservative strategy were implemented with very aggressive managers what would be the effect on the overall level of risk?  Probably less than you might think.  Assuming that the managers don’t have systematic bias to be long or short of the market, then to add the risks you have to add the squares of the risks.  (It’s the effect of diversification, when your asset strategy is doing badly, your manager might be outperforming and vice versa.)

10.02 + 4.02 = 116 = 10.82

So even in this extreme case, the overall level of risk has been increased by only 8%.  In our experience when looking at most strategies, the choice of active or passive makes no discernable difference to the overall level of risk.

This means that if you find a fund manager that you believe adds value (after fees) then using them will be a great use of your risk budget, because the additional risk is likely to be negligible.

Conclusion

When deciding on active versus passive for defined benefit schemes, the argument is quite straightforward.

If you can find a manager that you think will add more value with their “bets” than the cost of the additional fees, then use them.  If you can’t, then don’t.

Discussions about whether the market is likely to rise, fall or meander along are irrelevant.  And normally so is the additional risk to the pension scheme.

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