There has been a lot of debate over the years about whether active fund managers add value, or whether you are better off investing into a low-cost alternative such as an index fund or exchange traded fund (ETF).

The reality is not as simple or clear-cut as the marketing teams on either side make it out to be. You need to be very careful about what you invest in, and therefore make informed decisions.

Caveat emptor - the principal that the buyer alone is responsible for checking the quality and suitability of what they are purchasing - is a phrase that is becoming more important than ever. In this article, we look to explore why this is the case.

First, let’s revisit the main tenants put forward by each camp:

Passive management:

Pros: Cons:
  • Low Cost
  • You have no control over the investment
  • Simple to Understand
  • Poor risk management. You buy everything - the good, bad and ugly. Volatility and risk may be high
  • Liquid - as in able to get your money quickly
  • Heavily correlated to markets - because they are the market
  • Effective in rising markets
  • Not available in all markets or across all strategies as they are too hard to replicate in certain situations, e.g. long/short, hedge funds or direct investments
  • Diversified - across the whole market
 
  • May be suitable for passive investors with low amounts to invest
 


Active management:

Pros:  Cons:
  • Can be higher quality due to educated/informed investment selection by managers 
  • More expensive as they employ more people and resources. Higher fees do make a difference over time
  • Can provide better protection of your capital in down markets
  • More opaque - it's harder to know what you specifically own at a point in time
  • Can react to and take advantage of market dislocations
  • Man branded 'active' managers are not really active managers. Many are simply focused on tracking the market and charging higher fees for the privilege
  • A much broader range of markets and strategies are available to investors
  • Good active managers are hard to find so it can be simpler not to bother
  • Can more specifically target outcomes
  • Getting the most from active managers requires expert help; without this the benefits will probably accrue to someone else
  • Can allow investors to better customise portfolios to their specific needs
 
  • They provide the opportunity to outperform the market over a full cycle and with less risk
 

Irrespective of pros and cons, each offering has its place and can be the most suitable solution for a given situation. There may be no ‘right’ and ‘wrong’ in the choices we have, they are simply choices.

What concerns me right now is that due to the success of low cost index type offerings, billions of dollars have been pouring into them. This is all well and good until you realise that more money buying these index funds means more money buying the ‘market’, thereby becoming a self-fulfilling cycle that drives the market up. This is great, until the music stops and the money flows reverse. At that time the market is sold regardless of merit, with the inevitable result being the market falls.

This has the potential to create more volatility in markets than may be warranted, which has a knock-on effect of potentially hurting investors. Many investors have a misconception around passive investing, thinking that they are safer there.

A significant problem I see with passive, low-cost index investing is that the success of the moment is that they are all carried a tidal wave of uninformed money. Their ‘success’ is not based on well-reasoned, fundamentally driven investment acumen and (out)performance. It’s blind faith (gambling) based on smart marketing about how cheap they are, and the fact they’re going up (for now). It’s great if you can time markets and they’re on the way up, but it’s the downside and the awful impact that can have on well-meaning but ultimately less informed investors. Most investors do not have access to the same information, in as timely a fashion as professional investors, so it’s not exactly a level playing field. There are two sides to every trade, is how the old expression goes.

This is precisely where active managers should step up to the plate and earn their fees. Through their research a good active manager should sort the good investments from the bad and, on the whole, provide a higher quality portfolio. In a market downturn, such a portfolio should fall less than the market, that is, they should help protect your capital. Ultimately, this is a very important point to consider. It’s all well and good to make great returns but it can be irrelevant if you lose it all the next day, and we all know that putting money aside to invest is not that easy in the first place. Protecting it makes sense. Avoiding large drawdowns is essential to achieving good long term compounded returns.

It seems to me that as investors we’ve all become a little complacent about risk and for some reason we expect markets to go up forever, which is no surprise after a very long bull market. In this environment, low-cost investment offerings seem very attractive. Lots of stats are quoted about how few managers can add value after fees and so forth. It’s a tough gig for any active manager when money pours into markets, sometimes without merit. What can they do? Abandon disciplined investment fundamentals and follow the markets?

But markets do not go up in a straight line. There have always been periods of significant dislocation throughout history, in every market, be it shares, property or fixed interest. Remember the GFC just a short 10 years ago? It would be more than a little naïve to think it won’t happen again. In fact, despite what the general media and markets are telling us, there are very significant risks investors should currently be considering, for example: rising geopolitical risks, likely rising interest rates in much of the developed world, excess government stimulation following the GFC creating distortions in markets and valuations of some assets, most notably the Australian housing industry and US equity markets. Astute investors are being cautious for a reason. Whilst there are always opportunities within markets, if you’re buying the market, as in using an index fund, then there is no hiding the fact you’re taking a lot of risk at the moment.

Now of course not every ‘active’ fund will do well and protect your capital and there are good and bad managers out there, so this is where the ‘caveat emptor’ phrase comes back into the conversation. Careful selection is warranted and absolutely necessary. Take the time to find the good managers. They are out there. We know because it’s our job to find them.

Find the managers that match up to what you want to achieve in your investment portfolios, and that you can trust to look after your money. It’s worth the time and effort to think about these things. It is less effort than it would be to replace any lost capital anyway.

Alternatively, find someone that can help you match up good investments with what you want to achieve. It’s your money. How actively do you want it looked after and are you prepared to pay someone to protect your capital and do a good job of managing it for you?    

 

By Mathew Walker