The great debate – Active versus Passive

Why have passive funds attracted so much money recently?

It’s a very simple equation. One is that only 25% of active managers are good enough to outperform their benchmark. That’s good but it also means 75% of fund managers are charging fees far to high for the underperformance they are delivering and are thus losing funds under management. Then only 5% continue that performance of 3 years. That leaves a very small pocket of fund managers that provide a good service for fee arrangement for you. AFR journalist Philip Baker describes it as fund managers ‘dirty little secret’. Why people give poorly performing managers their money I have no idea. It must be something to do with crowd behaviour I think.

For those investors however there is an apparent alternative. New markets have opened up such as the ETF market, which is a new low cost way of accessing the market and it’s growing at a phenomenal rate. This is the ‘passive’ alternative. But remember markets, and the passive approach of tracking an index, go down as well as up and you still pay your fees. Plus there is an inherent ‘domino’ bug lurking in the ETF market, which I have previously outlined in the Radar Newsletter issue #420 on the 14th October, which is still available on the site under the newsletter tab.

It relates to the fact that as more money is attracted by ETF funds they MUST buy the underlying stocks on a weighting basis regardless of whether a stock is performing well or not. Stocks bought can be pushed to unrealistic levels. But then consider ETF fund withdrawals; it will leverage the falls of these stocks perhaps unnecessarily so. So fund inflows and outflows are affecting stock movements regardless of their fundamentals.

It’s the same old story dressed up in a different outfit as a market such as the ETF market is fine when the market is going up but alas investors also have short memories (repeat the cycle) because what’s going to happen when the market goes down and this is where the strategy flips on its backside. That’s when investors will grumble about performance but in fact it is their own fault. Time to wake up and stop being stooged. Fund investors are happy to win when the market goes up but not happy to accept the risks that go with that strategy. Markets don’t, and cannot, go one way all the time so why do investors have that expectation? It’s a mystery to me but the fact is investors are shirking the responsibility of managing their own money.

So what is it investors want? Steady returns regardless of the market direction, this is index unaware, and the safety of your capital, which is an imperative objective. Sounds simple and very reasonable but it is very had to find. Back to Philip Baker’s ‘dirty little secret’.

Just because active is out of favour it is still the best option because when the market turns all the ‘flavour of the month’ strategies go ‘pear shaped’ and then we grizzle. It’s of utmost importance that we know how to deal the down swings – and survive. That’s where the good active managers really earn their money, when the market is going down and they still outperform and more importantly preserve your capital by being mandated to have the ability to more into such assets as cash (safety). It’s all about coupling achievable returns with capital protection. A hard double act to achieve and only few do but there are managers out there that do it.

As I have iterated before the low cost of trading shares and taking the responsibility of managing your own money is a great option these days with low cost trading platforms and a good independent partner such as Stockradar as a guide for you. Making money on the stock market is a common sense process. Too often we look too deep. Stockradar’s focus on risk management and absolute returns is simply a common sense strategy that is prepared for all eventualities, as we must. Up markets, down markets and sideways markets.

Don’t forget the ‘double whammy’ of capital protection, through a strict risk management program, and stable absolute returns, from a quality stock picking strategy that ignores the weak and focuses on the strong, should be the objective of every stock market investor. Accept nothing less – why should you?