The active advantage

There are many vocal supporters of the indexbased approach to investment. It is hard to get away from the 10X ad campaign, which features Nik Rabinowitz. The academic, William Sharpe, wrote that after costs, the returns from the average actively managed fund will be less than the returns of the average passively managed fund. The compounding effect of higher costs is the single most important differentiator between the approaches.

I have come across the first coherent defence of active management for some time. It’s from Gavin Ralston, head of active allocation at Schroders. He also has the absurd Gilbert & Sullivan-style title of “head of thought leadership”.

Ralston says most of the focus is on pure equity funds, where there are arguments for an index strategy. But when it comes to a goals-based approach, the goalposts shift.

There is no passive way to replicate an inflation plus 4% strategy, even with a simple passive fund with 60% in equities and 40% in bonds. Such a mix of global assets would have provided real returns over 10 years of anything from a negative 5% to a positive 15%.

Ralston says a few active interventions, along the lines of “buy low and sell high”, can make outcomes more consistent. He argues that dynamic asset allocation is an active skill that cannot be replicated cheaply. I have yet to come across a computer that does it consistently well.

It is also true that not all investors are running the same race. Hedge funds aim for strong absolute returns and, in theory at least, take no notice of market returns.

Many large investors still use a mixture of active and passive. Some of this is de facto passive, such as the Public Investment Corp’s giant in-house fund, in which every major share is represented in a weighting quite close to its JSE weighting. And there is greater use of exchange traded funds (ETFS), a useful way to invest in niche categories or countries. Ralston says anyone wanting to invest in a small country such as Poland can do so quickly and cheaply through an ETF.

He says that, in any case, there is no evidence that the performance of active managers is in decline outside the US. But the reality is that active management is cyclical, and it has not done well in poor environments such as the months after the 2008 global financial crisis.

Buying shares at their cheapest

On average, managers have insufficient skills to identify the better-performing stocks when all stock prices are falling. That’s bad news, as fund managers could add most value by buying shares at their cheapest.

Ralston argues that active managers have a role to play in society. They set the price of securities, which helps enhance efficiency and maximise returns. Through their stewardship, they encourage higher standards of corporate governance and direct capital into faster-growing industries.

There has been less money raised on the stock exchanges in recent years, but with such low interest rates, why raise expensive equity finance? There will, however, be a renewed demand for funds from new, capital-intensive industries such as renewable energy.

It might seem obvious that ratings are the best solution to the environmental, social and governance problem, but they have notoriously poor predictive power. Agencies gave VW a solid rating prior to the emissions row; BP was AA going into the Deepwater Horizon scandal.

At least some active managers can help predict these changes, through their dialogue with management.

One of the arguments for active management is that there is no passive way to replicate an inflation plus 4% fund