Actually, it's not a competition
31 July 2017 | Topical insights
Ankul Daga, senior investment strategist with Vanguard Europe
Commentary by Ankul Daga, senior investment strategist with Vanguard Europe.
Debate about the relative merits of active and passive investment strategies is perennial. But it has become considerably more heated in recent years as investors have favoured passive funds.
Unfortunately, this heat can produce smoke that obscures our goal as investment professionals: to give our clients the best chance of investment success. Too often, the debate is framed in a way that puts our professional egos, rather than client goals, at the centre of the conversation.
The urge to win
Look, I get it. I like to win. When I watch a football match or game of cricket, I empathise with the euphoria of the winning team. And let me be brutally honest. This euphoria is not the sense of achievement I once felt when passing an exam. It's about winning. It's about vanquishing the competition.
Investing engages this same primal impulse. A market is made when two individuals agree a time and a price for the transfer of an asset. As the value of that asset subsequently rises or falls, one of those individuals will be deemed to be the winner. The other will be the loser.
The conventions of performance management crystallise this calculus in ways that can work against the interests of our clients. Our industry evaluates performance relative to market benchmarks (as we should), but with a short-term focus (as we shouldn't). Our egos are drawn into a competition measured in monthly factsheets, quarterly performance reports and annual updates. But our clients invest to finance goals, hopes and dreams that often lie decades in the future.
Active-passive through a client lens
What if we ignored the short-term performance derby and focused instead on long-term client goals? The active-passive debate would become much less heated, much more nuanced.
In our view, passive investing is the starting point for clients, if for no other reason that that it's simple and low cost, merely seeking to capture a market's return. But active can play an important role. The key is to recognise what it takes to succeed in active management over long time horizons.
A successful active strategy depends on three critical elements:
- Talent. To deliver long-term outperformance, a fund manager needs talent. This is a lot more than clever ideas and polished patter. It's a strong team, a time-tested philosophy, and a clear, consistent investment process – characteristics that Vanguard seeks when hiring external managers.
- Cost. The total return of a fund consists of three parts – beta, factor and alpha. The beta and factor components typically explain most of an investment's return, and they can be obtained at low cost. Our task as investment professionals is to make sure that any additional costs are commensurate with expected alpha. A rule of thumb? The lower the cost, the better the chance for net alpha.
- Patience. This can be a challenge, and this is where the quarterly performance derby can do so much damage. Every active manager underperforms the benchmark at one time or another. There may be occasions when this underperformance stretches over years. Does your client have the patience to sit tight through periods of relative weakness?
Reframing the debate
The active-passive debate has taken an unproductive turn. My proposal: Let's lock our egos in the file cabinet. Let's think instead about what's right for our clients. Suddenly, the active-passive debate becomes a more interesting and more productive conversation, with a richer set of possibilities for our clients.
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Issued by Vanguard Asset Management, Limited, which is authorised and regulated in the UK by the Financial Conduct Authority.