Active vs passive funds

IRRELEVANT: COMPARE THE COSTS – THAT IS WHAT’S IMPORTANT

The one – when done well – is expensive, the other not, study shows.

The rise in index investing has been the most significant trend in global asset management over the past decade. According to ETFGI, there’s now about $5 trillion invested in exchange-traded funds globally.

This growth in passive investments is due mainly to two factors.

Firstly, active equity managers everywhere have struggled to outperform market benchmarks. The latest S&P Indices Versus Active (SPIVA) US scorecard showed that less than 11% of US large cap equity funds outperformed the S&P 500 over the past 10 years.

Secondly, investors have been attracted by low costs. Index-tracking product fees have generally been well below those of active funds.

In the US, Fidelity Investments recently announced that it was launching products charging no annual management fees. So, it’s now possible to invest for nothing.

A recent analysis by David Nanigian at California State University suggests these two issues may, in fact, be the same thing. What’s the real difference? Nanigian’s study, titled “The historical record on active vs passive mutual fund performance”, looked at the risk-adjusted performance of funds in the US over from 2003 to 2017.

While he observed that, on a value-weighted basis, passive funds produced slightly higher alpha than active funds over this period, it was just a 0.62% difference per year. This isn’t statistically significant.

Nevertheless, over a 15-year period, it’s economically significant. Once you start compounding that difference, it becomes material.

Nanigian then compared the funds’ performance based on their expense ratios … with eye-catching results.

He found that if you compare active and passive funds with the same expense ratios, their alpha is almost identical. Active funds outperform by 0.04%. Both statistically and economically, that’s insignificant.

In other words, where funds cost the same, it doesn’t matter whether they’re active or passive. Over time, their performance is determined by their fees, not their strategy.

Take-aways

Nanigian has three “take-away messages” from this study for investors.

Much of the historical outperformance of passively-managed funds versus actively-managed funds is a result of expenses.

In today’s mutual fund market, there are many actively-managed funds with expenses comparable to those of passively-managed funds.

When passively-managed funds are compared to these competitively-priced actively-managed funds, “there’s no economically meaningful difference in performance.”

The central practical implication of this study is that as long as investors are cost conscious in their mutual fund selection process, the active vs passive choice is a moot point.”

The implication is that asset management has become a commodity. Over time, the only thing that will differentiate one fund manager from another is how much they have charged you.

Good active management is expensive. It requires teams of analysts, research and much computing power. Good passive management, however, is much cheaper to apply and has substantial economies of scale.