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Active vs passive management – is it worth it?

The investment management industry is evolving and there is now a wide variety of investment options available to retail investors. Whether you are looking for an equity, bond or commodity product the main distribution channels now offer access to all of these. Once you have chosen your asset class, the next decision is whether you want to buy an active or passive product. Buying an active product means that you are making a bet that the team you allocate money with will beat a predefined benchmark (eg Eurostoxx 600 or FTSE 100).

Historically, buying active products was the only way to invest in financial markets, but over the past few years the prevalence of passive investments has been growing. Buying a passive product (e.g. an exchange traded fund) is based on the belief that active products cannot beat the predefined benchmark. The goal of a passive investor is to mimic benchmark performance whilst minimising the product cost.

According to ETFGI, a research and consultancy firm, exchange traded products listed in European exchanges reached the $500 billion threshold in 2015. Only 10 years ago this number was only around $58 billion. There has been growth of more than 800%. The passive investment growth explosion is partially to blame for the drop in active products assets under management, many analysts argue this is structural, not cyclical.

The number of skilled managers with robust performance had been falling over time. Investing is a negative sum game: it is possible that active investors add value, but if they do, it is at the expense of other active investors. If cost is taken into consideration the end-performance of that active investment is dragged down.

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Academic research suggests that there is no clear evidence that mutual funds do better than the market when an investors long-term goal is taken into consideration. According to Ferreira equity mutual funds across the markets underperform the market overall, and in the US the fund size is negatively related to fund performance and there is some sort of short-run persistence in fund performance.1 In the bond space there is no evidence of positive performance after costs according to Chen.2 UK equity mutual funds are the exception, but only a relatively small number of top performing funds exhibit stock picking ability according to Cuthbertson.3

The first quarter of 2016 was the one of the worst according to Bank of America Merrill Lynch. They looked at US equity funds against the benchmarks. Only 19% beat their benchmark despite the greater return opportunities that come with higher dispersion, this performance is lower than what would be expected and some might argue that the difference is not only related to costs, but could also be due to a potential lack of skills too, this puts the business model of mutual funds at risk.

The current environment does not look great for active management and potential disappointment from the performance of the next quarters could accelerate the proliferation of passive products. What is still key in this environment is the right mix of assets (equites, bonds, commodities, and currencies). At Moneyfarm we blend these assets to provide an optimal risk adjusted return stream for investors based on the idea that the most important decision for investors is asset allocation. We believe stock or bond picking is hard to do in the long term, so passive exposure to asset classes with an appropriate rotation through market cycles and keeping costs low is part of the recipe to provide a solid long-term performance.

1 The determinants of mutual fund performance: a cross-country study, Review of Finance, April 2012
2 Measuring the timing ability and performance of bond mutual funds, Journal of Financial Economics, October 2010
3 UK mutual fund performance: Skill or luck? Journal of Empirical Finance, September 2008

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