Active or passive? How to choose right
03 May 2017 | Portfolio construction
Financial professionals almost always have views and preferences on active and passive strategies, but not everyone has a structured process for making the choice. In a recent Vanguard webinar, Ankul Daga, senior investment strategist for Vanguard Europe, discussed some points of best practice. This is an edited transcript of the webinar.
Andrew Surrey (moderator): Before we jump into the active/passive framework, let's look at portfolio construction at a high level. Ankul, how should investors think about portfolio construction?
Ankul Daga: Normally when investors think of portfolio construction, there are two dimensions. On the slide in front of you we have captured the asset allocation aspect on the vertical axis and then the active/passive element on the horizontal axis. Now as most of you would be very familiar with – with regard to asset allocation, most advisers follow a very systematic process. They typically tend to use a questionnaire to understand the client's risk appetite; they make an assessment of the capacity for loss and through a systematic, step-by-step process the adviser gets to the asset allocation which is suitable for the client's goals.
And do investors often use software to help with this?
Yes, there are different software packages out there which help advisers get to that precise asset allocation which would be suitable for their investors. A similar kind of process can designed to make that active/passive decision. It is a series of systematic steps which lead advisers to a particular blend of how much active investment and how much passive investment they might reasonably hold in a client's portfolio. And to a great extent that's the focus of our discussion today.
We know there's no one-size-fits-all solution for asset allocation. Are you saying that's the same thing for active and passive?
Absolutely. Advisers decide what is the right asset allocation for every single client. Similarly for every single client, the decision of how much active investment or how much passive investment needs to be decided case by case. I know a lot of advisers will have model portfolios, but again I think what one needs to appreciate is that when you select active investments you add another layer of risk over and above market risk.
In pure asset allocation, clients are taking on board market risk, but then when you decide to go with active managers, you are taking on another level of uncertainty. Some clients will be very comfortable with it and some clients won't, which is why we can't have one solution which fits everybody, but rather need to take a client by client, case by case approach.
This isn't the way it's perceived in the market is it, or in the media? You know they have a very different approach.
Well, quite often you see headlines in the press – 'Passive outperforming active across the board' or maybe your active fund manager doing spectacularly well, outperforming the benchmark by, I don't know, 500 basis points. So you have a lot of different kind of news items floating around, which gives the impression almost as though active and passive are at battle with each other.
We at Vanguard don't think that is the case. In fact the focus for advisers should be to try and deliver value to the end client, and that value can be delivered by selecting active funds or by having passive investment solutions, which give a very efficient exposure to the market. What we should be thinking about is some kind of balance between the two.
I think what we find would be even more useful is to make a very explicit and deliberate decision around it. So to look at the different characteristics of active investments or passive investments and have a very systematic process to say 'What is the right blend to have?' At the end of the day by selecting any active manager, the adviser is making a decision, albeit implicit. What we are almost urging here today is for that decision to be explicit, and as we go through the discussion today I'd like to go through different aspects, different dimensions that advisers consider in coming to that conclusion.
You're asking advisers to make it a more conscious decision – is that, when you say 'more explicit' –
Yes; absolutely; I think –
– making a belief into a framework that can be used time and time again?
Yes, that's reasonable.
Ankul, you mentioned a couple of times about finding value. How do investors find value in active fund management?
Let's look at active fund management and the dynamics behind it; this is something we quite commonly call the zero-sum game. So if there are let's say a hundred investors out there; half of them will be above the benchmark; half of them will underperform the benchmark. So on the chart here, what you see is a bell curve where half of the investors are beating the benchmark; the benchmark being reflected by the vertical straight line and right in the middle, and these outperforming investors are highlighted in blue; the underperforming investors are highlighted in grey. And for every winner there will be somebody else they are trading with and who is losing value in some way, shape or form.
Now if we go and look at the next slide, what we see is the impact of cost on all of this. So we start from a conception construct, but then when we apply the reality of trading, of administrating these funds, these portfolios, there is a significant cost drag on all of this, and what that really means is that the blue portion of outperformance starts shrinking. So by definition outperforming through Active management is going to be difficult; in fact when we move from the conceptual picture, when we look on this slide to the real picture, of what happens from one asset class to another, we see that active management is really difficult.
Let me talk through this slide. On this slide what we are trying to show is the percentage of funds which are under performing their benchmarks, asset class by asset class. So you have equities on the left, starting from global equities to UK equities, and then bonds on the right-hand side. On these bar charts, the dark blue are the percentage of surviving funds, which underperformed their benchmarks, and the green is essentially funds which have to liquidate or merge, which we're calling, let's say dead funds.
Now at the end of the day investors have put their money in all of these funds, and as a consequence, you see the performance that the investors would have achieved had they invested in each of them asset class by asset class. And we put a line right in the middle of the chart in grey, just to highlight that other 50% of clients. If there was no cost you would expect half of them to outperform, half of them to underperform, but across all of these asset classes, most of these fund managers, or a large proportion of these fund managers are under performing.
An investor looking at the simple sector average of a UK equity peer group might think that more than half are outperforming. But over time the average will be impacted because some funds will have been closed or merged.
I think there are those kind of, let's say misconceptions out there where if this evaluation isn't done properly it can lead to a false impression. So at the end of the day we've got to follow how investors are invested rather than how, or what fund managers are looking at as of today. So when we did this analysis we focused on the last ten years and we looked at all the funds that investors invested in and typically the funds which actually liquidate or merge are funds which have either underperformed or have had a significant issue. Funds are not typically liquidated when they've had a very big outperformance.
Vanguard believes in active as well as passive. What steps can investors take to improve their odds of success in both strategies?
When we looked at this the first question we were asking ourselves was 'Why is it so difficult? We know outperforming in active should be a little bit difficult, but why is it so difficult?' And the first reason we came down to was cost.
So what we started doing was, we actually broke the whole segment of active funds in the UK into four branches or four quartiles. So the chart in front of you – you see the lowest fourth quartile in green and the highest fourth quartile in blue. Now regardless of what strategies the fund managers were taking, we just indiscriminately – just started looking at the performance of these quartiles based on cost. And what we found was when you look at it over ten years, 15 years, 20 years or even 25 years, the lowest-cost funds tend to have better odds of outperforming compared to the higher-cost funds.
Let's look at the statistic for the lower cost fund, the 38%. So over 25 years, 38% of the lowest-quartile funds have managed to beat the benchmark compared to only 13% of higher-cost funds, which is quite counterintuitive if you think of it, because in most other industries – let me start with cars or automobiles – you find that there's a premium for higher-quality vehicles. But in asset management that logic doesn't work because a penny paid in cost is a penny taken out from the return that an investor achieves.
And what is the persistence? Do outperforming funds come out over time?
In fact what you find is the longer the time period, the more chances of a lower-cost fund outperforming, because there's much less burden on that fund.
Absolutely; so first is the cost burden itself and then the compounding; so if you're starting off on a lower base, then the chance of it growing over time is also reduced.
And it's not just Vanguard that's been saying this, right? Russell Kinnel, the fund researcher at Morningstar, has said the number doesn't wait – the only thing you can take to the bank is the expense ratios. They're the most dependable predictor. The FCA [Financial Conduct Authority] in their interim report on asset management made similar points, – that cost should be a primary part of your fund selection process. Is that you endorsing those themes?
Absolutely. I think this has come into focus a lot right after the asset-management market study by the FCA. I think the first thing is cost matters. So the cost definitely matters, but along with cost it's really important to find a talented asset manager.
Because low cost doesn't guarantee anything as you were saying, right? It doesn't guarantee outperformance?
Cost makes outperformance easier, but that by itself does not lead to outperformance. It's the talent that the manager has, or the value that they bring to the table, which really matters. So we at Vanguard do a lot of work around finding talented asset managers. We look at the firms, the individuals involved, what is the process they are following, and then the acid test really is if their performance really is aligned to the philosophy that they're signing up to. That will lead to fluctuations like any other kind of market dynamic, but if they are able to deliver value, then that's an investment worth considering. So what we try to do is find talent, minimise the cost to accept that talent or make it proportionate to the talent that we are looking at.
Coming back to value again ...
If we bring it back to value, one of the very interesting observations we had when we looked across the market was that quite often there are asset fund managers who add value, but they charge way too much for it. They probably – let's say if I was to throw some numbers here, they might be good fund managers who are adding 100 basis points of alpha, of outperformance, but then they charge 100 points, or 150 basis points for it and the process is that the end investor doesn't get any of the benefits. So there is the talent; there is making sure the cost base for it is sensible, is reasonable; and then the third aspect is having patience with them. Because active fund managers and active fund management in itself can be cyclical, it's important to be patient with them and actually to hold on to them as long as they are following the policy that they have laid out.
And if the key strategy is still in place, I presume – if the fundamentals haven’t changed, then you're saying, 'Even if they're underperforming, hang on in there'?
Absolutely; I think what we find is a lot of the good active fund managers will have down years when they underperform, but the important thing is the reason for that underperformance. Are they underperforming because of the style they've chosen, whether that be value or small-cap, or is their underperformance because of some other factor?
Now if their underperformance is because of bad risk management you've got to be concerned. But if their underperformance is because value is underperforming growth, that's fine; that is explained in itself. So typically at Vanguard we tend to hold the active fund managers we choose for about 14 years, but that requires a lot of patience and it's this patience, along with all the other good stuff that the manager is bringing to the table, that will then deliver the end value to the investor.
Fantastic. That's really good Ankul, thank you. So let's have a look in more detail at a structured way to figuring out how much active or passive to hold in investors' portfolios. Let's start to take that belief and put it into a framework.
Sure. Let's go back to our initial slide around portfolio construction. We are pretty familiar – or most advisers will be very familiar with the asset allocation process where they are assessing the risk appetite the client has and the return the client seeks. We start to do something similar with the active/passive risk here; so we first look at the return dimension, then we turn to the risk dimension and then try and complete the picture. What are the key ingredients to all of this? In a very simple binary world there are only two things to consider; there is alpha that a manager would get and there's the cost they charge. So just looking at these two dimensions, let's look at this chart.
What we have put down is the cost on the horizontal axis, and the expectation of alpha on the vertical axis. Now if a manager is going to outperform their benchmark and deliver some alpha, the moment the positive alpha they're going to offer is higher than the cost they're charging, I'm going to go all active. So in a very simple world where all I have to consider is the potential for outperformance and the cost spread, the moment the outperformance achieves both, I'm going all active. And what you find here is on this chart, that approach is highlighted through the red boxes and then the passive approach is highlighted through the blue boxes.
Now the difficulty here is even when you know a manager is a good manager and could outperform, we know that costs are guaranteed, but outperformance is an expectation. And it's really important that advisers take a very conscious approach and quantify this outperformance. So the manager's clearly quantified the cost that they'll charge for advisers to access their funds whether that's fifty basis points or 100 basis points or 150, but advisers are hoping to get a grip of how much outperformance they're getting for paying that hundred basis points.
You're saying, 'Be explicit about it'?
You're saying, 'We think this fund can do 150 basis points above the benchmark over a reasonable time period' – that explicit?
Absolutely, and I think advisers need to kind of vote with their feet here and say to a fund manager that you're charging me 50 basis points for this fund; what value am I getting out of it? You know for that 50 basis points am I getting the opportunity to outperform by 150 basis points? And if let's say in this example, if the fund manager says, 'Yes you're getting that opportunity,' then they can ask 'How; what is your process; are you managing the risk around it?' But I think this is a question worth asking and getting clarity on because then once the adviser has that answer they can sit in front of the client and recommend that fund with a lot of confidence.
We're just looking at the returns – gross return, net return – surely you've got to put risk into it as well?
Yes, let's turn to the risk aspect of all of this. Even when you pick, let's say, a successful fund – on this chart here you've not just the potential returns of a successful fund which has been at its benchmark. The benchmark is the vertical line going on the left-hand side of the chart; the average return of this active fund or active portfolio is higher than the benchmark itself. So in this particular case you can see that even when you've got an active fund, which is going to beat its benchmark, there is a potential that it can underperform the benchmark from time to time. And that is a risk that advisers are taking on board because they could have easily had access to the market through a passive vehicle.
And at ten, 15, 20 basis points, so virtually free.
Passive gives access to the market for very, very limited cost. But then they've chosen to go on board with active fund managers and that adds another layer of risk to the portfolio and even with a good, successful fund manager, there is a potential for underperforming.
But it's a likelihood isn't it? It's not just a potential. Virtually all managers are going to have to underperform, even when they are ultimately successful?
I think for some proportion of time they are going to underperform and I think that risk has to be understood and has to be measured. And a common measure used across the industry is tracking error to see how much is an active fund deviating from its benchmark.
The first thing is for advisers to understand how much is the fund deviating from its benchmark, and then the second aspect to this, is how does the investor feel about that? So does the investor feel comfortable that when they take active funds on board there will be fluctuations, or does the end investor feel very uncomfortable about any underperformance? Because we have got to think of a scenario where, let's say there is a correction in the market and the active fund that has been chosen underperforms; will the investor be let's say disturbed or upset about just the underperformance or a loss in the portfolio or will they really care about loss compared to the benchmark itself? Because if they're going to be concerned about loss compared to their own benchmark, then maybe active is not the right route for them to take in the first place.
And this is where advisers can add huge value by understanding a client’s risk appetite. Robots have to use index solutions because they can't get to understand another human like that and they can't do that coaching aspect when a fund underperforms. Would you agree with that?
This is where an adviser can play a very significant role for the client in educating them in almost stepping away from the emotions involved in investing and making sure that the investor's portfolio is aligned to their cause. We've looked at the two return aspects so far and then the risk aspect, and I think when you put everything together, then you have a very systematic framework, which can help you make decisions.
Putting together the return and the risk. Let's have a look at what that looks like.
Right. We've looked at these four dimensions. Let's go through them one by one again. So the top two lines are the return dimensions, which is the expectation for alpha before cost; then the cost itself and then the two risk dimensions, which is how much active risk, how much deviation from the benchmark is a manager taking, and then how does the client feel about this; what is the client's risk tolerance towards this deviation away from the benchmark?
The top three are fund-specific about funds you're looking at and the bottom one is investor-specific?
That’s right. If a fund has a potential for giving high levels of alpha or outperformance, in that case going active becomes even more attractive. Similarly if a fund is available at a lower cost, that means that more of the returns will get to the client; so again going active makes a lot of sense. Similarly, think of the active risk in terms of tracking errors. If a fund has a very high tracking error, then there will be a significant deviation from the benchmark from one year to another.
It could be hard to hold onto over time.
It could become really much harder to hold because after maybe one year or two years of underperformance the client might not have the patience to hold it any further. And that's where I think on each of these aspects, the adviser needs to make a very, very clear and conscious decision, you know – 'What is the alpha you are expecting? Is it 100 basis points, 200 basis points, 500 basis points? What are the costs you are paying?' Now typically cost is very well disclosed and understood. What about the tracking errors? That's another statistic that can be gotten fairly easily through a number of different providers.
The final piece is the patience element, which is something that advisers would evaluate and discuss this with their client, and this is where the human element is very critical. And at the end of it once you've gone through them systematically, then making a decision over the proportion of active or passive, which is suitable for the client, becomes a lot more clear, and this is where I think without the framework – we're almost trying to shift our audience from one where they have total embedded belief or implicit assumptions all the way to one where they have explicit expectations.
Because at the end of the day, as we know it, portfolios are not just born; they have to be constructed; they have to be put together brick by brick, systematically, and just that deliberate process where having a systematic repeatable process is very critical.
Ankul, as you've sat on many investment committees – I assume you always document this? You make sure it's robust; you can pull it off a shelf when a regulator or anyone ever asks for evidence of why you make this decision?
It's very important to document this process because you want to get the best outcome for the end client, but along with that you want to be able to defend it and explain it to the client. Because if a process is based on belief, as organisations change the process doesn't remain as robust and you can't repeat it systematically. So documenting it is a very, very good practice, which would help advisers follow that process, keep it robust and have that confidence when they sit in front of clients.
Interesting. Let's look at that in a different way – where we've got those four tilting bars – let's have a look at it in a different way, bringing in the risk dimension.
Yes. We've looked at this chart earlier where we've considered just two dimensions and let's superimpose the two additional dimensions on it, the risk dimensions.
This is where the top left is poor value from an active management point of view, the bit on the right is high value.
Yes. So if you just focus on the top left, you're getting a high-cost fund, which is likely to give you small or low alpha. Now at that point the outperformance might not be commensurate with the cost that you're paying and in that case going passive makes complete sense. But the fund on the bottom right, you're looking at a fund which can give you high alpha; high outperformance at a lower cost; in this case the investor would go completely active, right? So this is just the return dimensions to it; now let's look at the other two risk dimensions to it, which would look like a spectrum of colours.
So this is the same nine boxes, just with a couple of dimensions added in?
So walk us through the extra boxes.
Let's focus again on the top left, which is low alpha but high-cost. Again there we're going passive, which is the blue colour all the way around, and then let's look back at the same example which is on the bottom right where you have high alpha but at a relatively reasonable cost, and in that case the investor would go largely active.
What I'm going to try and do is on this chart I'm going to highlight the risk dimension by focusing on the box which is on the bottom left; so where you see your mix of colours going from green to red. So on that box on the bottom left, you can have an investor who doesn't have a lot of patience or a lot of risk appetite and has invested in an active fund, which has high costs but also high alpha.
For the same kind of investment you have an investor who's very patient and you have another investor who's not very patient. The investor who is very patient and can tolerate a lot of tracking errors, would likely go very active, which is highlighted by the red dot on this chart on the bottom left. Whereas another investor who doesn't have a lot of patience or tolerance for active risk, and has invested in a high-tracking-error fund, would find it very difficult to hold onto this active investment and hence might be a lot more comfortable with a relatively low active allocation.
Again I think what we are trying to get to here is not the extremities of 100% active or 100% passive, but rather trying to find a reasonable solution where the client has exposure to potential outperformance, to active manager, but at the same time they can hold onto that strategy for much longer.
The most important decision is the strategic asset allocation, but however you balance the active/passive decision, it's important to have a systematic process. It's important to find value for the client and, as with asset allocation, there is no one-size-fits-all.
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