In our paper An explanation of Active/Passive we address the active versus passive investment question: pick stocks or buy the market? We put forward an agnostic case for opting out of active management, or security selection, in favour of a passive approach of ‘buying the market’ through a cheap and efficient index fund. It’s agnostic because it doesn’t rely on disproving philosophical or theoretical claims about market efficiency but focuses on the evidenced costs and payoffs of ‘playing the active game’. The costs and payoffs have both an industry-structure and a behavioural explanation. Each is loaded against the investor. The smart thing to do is opt out. We summarise the paper below. You can read the paper here.
All investors recognise the importance of asset allocation, or exposure to types of asset and to markets within an asset type. Think stocks versus bonds versus cash. Think UK equities versus US equities. They generally expect it to be a dynamic or active process, whether the activity is fast or slow; whether it’s conducted primarily for return-seeking motives or to manage risk. But when it comes to how the market exposure is to be implemented, there is an endlessly raging debate over whether to invest in ‘the market’ essentially in its entirety, a passive approach, or to pick securities (or funds that pick securities) and actively manage the security selection.
That battle is often described as active versus passive, a phrase focused solely on the implementation approach: pick stocks or track the index. We address the debate here but as the context for explaining a sensible pragmatic solution: active/passive. This combines a dynamic approach to asset-class and market selection with passive implementation via index trackers within each market. It is superior to an all-active approach that combines active asset allocation and stock picking and in which either may explain exposures. And it is superior to an all-passive approach that adopts a static asset allocation, with component weights simply drifting with market movements.
The arguments are not particularly technical, being practical rather than purely evidence-based or theoretical. This is important because we need to accept that statistically the battle can never be won by a knock-out blow from one side or the other.
These pragmatic arguments are applicable to all investors, both institutional and retail. They have already swayed investment consultants, trustees and owners of capital all over the world. However, they are particularly compelling when investment portfolios are organised to deliver quantified outcomes, within specified tolerances, at particular dates, as they are at Fowler Drew. And they are most compelling when the cost/benefit of stock picking is a function of slim potential rewards, set in a zero-sum game by investors competing globally, and the fat costs set by UK private-client investment firms.
Active/Passive allows UK private clients to benefit from effective risk management whilst also offering scope for additional return that is not the product of a zero-sum game. There does not have to be a loser for every winner. Both the core returns and the potential incremental returns can be captured at very low cost via index trackers.
For the UK individual investor, playing the active game costs about 0.7% pa, made up of annual management charges of typically 0.7% compared with tracker costs of 0.15% for a globally-diversified spread of markets, plus incremental transaction costs of about 0.15% pa.
However, the behavioural effects of playing the active game as a retail investor have been estimated to impose an even greater cost, averaging 2% pa (Vanguard).