The debate over whether active investment is better than passive investment has waged for years. Both camps insist that they offer the best value for investors and in some ways both are right. However, the investment world is about to change given the success of the Climate Change Conference in Paris.
There is a very strong argument in favour of passive when it comes to fees; passive funds are generally very low cost and all they aim to do is produce the same return as the market they track. Active investment managers charge higher fees and have the aim of providing better returns than the index. If they can’t produce a better return whilst charging fees, then investors may as well pick any old passive fund and save money.
The active fund management industry does have a particular handicap when it comes to justifying fees -the generally low standard of fund managers! Now, I appreciate that this is a rather sweeping statement but the evidence, I’m afraid, supports my view. There are lots of statistics which consistently show that anywhere between 55% and 75\% of active funds do not beat the index. In every one of these instances investors would have been better off paying lower fees in an index/tracker fund. The active managers who didn’t beat the index were overpaid by overcharging customers. Controversial view? Perhaps, but happy to hear from active managers who underperform their index to justify the fees.
Right, having provided a really good case for everyone to invest in Passive funds, I am now going to completely demolish the entire passive investment sector. As far as I am concerned passive investment management died when 195 countries ratified the Paris agreement. Active managers now have to step up and justify their fees.
Why has passive died?
The answer is quite simple. The very thing that provides the simple low cost structure of passive funds is now going to be their downfall – tracking the index. Unless investment companies start to manually intervene in the way the computers control the passive funds then they will suffer the consequences of the Paris agreement.
Let me explain; passive funds aim to hold the same shares in the same proportions as the index. A tracker fund cannot exclude a share that is in the index – the shares of every company must be bought and held. If the value of a company falls then a passive fund will reduce the holding in this stock but the fund will still hold it. If a company’s share price continues to fall, then passive funds will sell these shares to rebalance the overall weighting thus driving the price down leading to further selling.
Normally, a share price will fall to a level where active buyers feel it has gone too low and they see this as an opportunity to buy cheap. If there is more general buying then passive funds will realign by buying, thus driving the price up again. What happens if the active managers don’t come back in and start buying again? Well, the active funds will continue to hold the stock, the prices of the stock will continue to fall over time and they will then sell, sending the price down but still continuing to hold the stock as it falls, realigning the weighting, selling, realigning the weighting………
Even the worst active managers have the ability to get out of a company’s shares once it looks like all of the value has gone. The good ones will have got out much earlier – at a much higher price. But, the point is that active managers can exit but passive funds are trapped in holding a stock until it disappears from the index. The funds are trapped into making losses that active managers are not.
Post Paris, then, markets will come to realise that many of the biggest companies we know today will either have to radically change or drift away. The drifting will be as a result of a move away from fossil fuels and into renewable sources of energy. The next generation of top companies are on the way now and the old guard will have to move out of the way.
Paris has introduced a new paradigm in the investment world; low cost passive funds would remain low cost and at the same time become less and less a credible investment option. Hanging on to the shares of shrinking companies whilst active managers can switch their attention to the new growth companies will be bad for investors. Looking ahead, the higher fees charged by active managers will pay off, even if some of those managers are still not very good – they won’t have to be to be the passive funds!!