Thursday, 4 August 2016
The debate between passive management proponents and active management supporters has verged on ‘religious fervour at times over the years, but has the worm turned following on the heels of events like Brexit, the US elections, the refugee crisis in Europe and the Syrian war?
Widely regarded as the cheaper and sometimes safer option, passive fund management involves buying a specific index fund, for example, the NZX50, FTSE100, S&P 500 which may be constructed in many ways, but represents a specific portion of the overall market.
The problem with that line of thought, says Spicers Managing Principal, Hawkes Bay and East Coast, Tobias Taylor, is that the index fund may miss out on companies when they are in the growth phase.
“A lot of index funds only focus on large cap big companies, when the opportunity may be elsewhere. While there are small cap ‘smart beta’ funds in the market, by and large, you’re buying the biggest companies and your valuation can follow erratic market movements. We have seen this with a number of global occurrences (Greece, China and Brexit) in the last 12 months”.
Active fund management, on the other hand, is generally the costlier option. However, it may also offer greater returns because it uses fund managers to buy and sell stocks to maximise investment performance.
“The most important thing is for you to understand what you are investing in and what it offers your portfolio. A portfolio needs to be goals and needs based. The style and solution comes from that discussion with the client”, says Tobias.
Director of Heathcote Investment Partners, Clayton Coplestone, says you get what you pay for.
“Passive management does extraordinarily well when everything is predictable. The investment process itself becomes commoditised, and you can afford to differentiate by price”.
“However, we are now in an environment that is not always predictable, and you need to consider risk management more than your upside returns. For example, if you are ‘passive’, and there is a geopolitical event, then you will be fully exposed to that event”.
Clayton says that active management involves an active manager who, in exercising foresight, can act quickly to protect the investment.
“My opinion is that at this stage of the cycle you are better off investing with people who can be nimbler and more focused on capital protection, but you will need to pay for the benefit of those skills”.
“Advocates of passive management talk about the efficient market, but that theory suggests that markets have perfect information and it is really difficult to exploit opportunities anyway. The reality, however, is that there is so much information out there that it is not the information that is the challenge. It is the access and the assimilation of the information that is the challenge”.
Clayton cites the 1960s and 1970s as an example of a time when there were stocks known as ’Nifty Fifties”, such as Kodak and Panasonic. During that period many investors were advised to adopt a passive approach to investing.
All but one of those stocks no longer exist. Without the ability to act, investors would have been exposed to the majority of Nifty Fifty stocks that have disappeared.
Today we have FANGS – Facebook, Amazon, Netflix and Google – and, as in the days of Kodak, there are people who are saying those stocks will never go down.
“The problem is that the price to earnings ratios (P/E) are in the hundreds – Amazon itself is over 500 – so it’s going to take a long time to recoup that investment. If you go with passive management, regardless of whether you think FANGS have a strong outlook or not – you will still be exposed and have no say in the matter. An active manager will appraise each of the stocks to determine whether the investment metrics stack up”.
Clayton says that investors have enjoyed a fantastic investment environment over the last 30 years – with falling rates fuelling stock and property prices. This in itself created a great haven for all sorts of management styles, including passive management, but the reality is that the fuel for these good times – lowering interest rates – no longer exists going forward.
“We are living in a time when it is becoming more about mitigating risk. The world has changed. Smart people said that Brexit would never happen. In the US we have a change of leadership, there is potential for a break-up of the EU, and Turkey and Russia are at loggerheads over Syria. And with such unprecedented political and economic volatility, now is a good time to consider active management”, he said.
Regional Manager & Authorised Financial Adviser
Director of Heathcote Investment Partners
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