The art of being passive

February 26, 2010

Hundreds or even thousands of  ”active” fund managers are competing to add alpha to beat benchmark indexes, be it in stocks, bonds or alternatives.

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The market is so efficient, historical performance is no guide to the future. It’s nearly impossible to find a reliable method to pick advisers who deliver the best industry returns year in and out. There are also costs, from visible ones such as management fees and custody and administration expenses to “below water” costs such as trading commissions (due to higher turnover), bid/ask spread (price to buy, another to sell) and market impact costs (larger buy/sell orders affecting price).

Given this, is there a point in investing in active funds? What about just diversifing your assets through passive indexes?

This is the philosophy behind London-based fund Frontier Capital Management, run by Mike Azlen.

Azlen told a briefing in his Berkeley Square office this week how a passive approach beats active investment most of the time.

Frontier’s fund invests in 8 classes and over 15,000 securities in asset allocation which closely mirrors one by endowment funds such as Harvard and Yale University. Azlen reckons average actuve fund expenses would be around 2.3 percent (or 9 percent for emerging market active funds).

“It is in the human nature to think that activity is a good thing. In this case, inactivity is a good thing. Instead of trying to fight the market, you can beat the market with (passive investing). The market is so efficient, you can piggyback on all their hard work and beat them,” he says.

The fund is annually rebalanced — saving the cost of frequent turnover which leads to trading commission and the management fee is 0.75 percent. Benchmarks which Frontier uses include the MSCI World Total Return Index and Barclays Global Aggregate Bond Index.

S&P data shows that over 5-year marekt cycle from 2004 to 2008, the S&P 500 outperformed 71.9 pct of actively managed large cap funds. A majority of active funds in eight of the nine domestic equity-style funds were outperformed by indices in 2008 and the bear market of 2000-2002 showed similar outcomes.

Frontier’s funds returned between 6.2-6.9 percent per annum in 1999-2010, outperforming FTSE index which rose 3.1 percent or hedge funds which gained 5.9 percent.

But of course, as Azlen says, history is no guide to the future.

One comment

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For those of modest wealth there is an advantage to picking the stocks yourself across the sectors yourself rather than buying into passive funds.
You will be averagely lucky even if you don’t exactly track the index, and why be obsessive about that at long as it’s a 50/50 overperform/underperform probability?
Individual stocks will have a much greater divergence over a financial year than any passive fund.
If you buy separate stocks and split them between yourself and your partner you can take your full capital gains every year because at least some of them will go up – bed-and-breakfast them between the two of you. That would get you £20,200 tax free gains locked away even in years when the FTSE has fallen.
When I say ‘pick’ I do not mean attempting to pick winners – somebody out there is doing worse than average and it can’t be funds that outperform the market before costs, of necessity it can’t be a random selections, so it must be punters following tips or stockbrokers recommendations.
If you do this consistently, cashing in your winners every year you can also build up a bank of capital losses potentially to offset a sale of a second home etc.

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