Active vs. Passive…are we having the right debate?

29 Aug 2017

The debate between an active or passive approach to investing has been around for more than 20 years. There are pros and cons to both arguments and generally any debate ends in a stalemate.

In recent conversations with clients we have noticed a shift in this debate. We believe that the traditional active vs. passive debate is too broad and vague, increasingly we see discussions on investing in equities focusing on:

  1. Passive investing vs. Core Active (Core)
  2. Concentrated investing vs. Core.

Splitting the debate into the above sections, provides investors with more definitive results and, we think, therefore offers more actionable (and valuable) outcomes for investors.

In our view, it is the second of these debates that is garnering the most traction within the investment community. This research insight puts the spotlight on the Concentrated vs. Core debate and uncovers why, we believe many investors are allocating away from Core to Concentrated portfolios. We conclude that investors that want to beat the benchmark should focus on identifying quality Concentrated managers rather than Core managers.


Where are investors allocating today?

For the purpose of this paper we briefly define each group:

  • Passive: An easy and low cost way to get equity market exposure (average of 200 stocks). Passive strategies are generally full replication with a low risk profile (tracking error of less than 0.50%). This approach tends to provide index returns less fees.
  • Core: Currently a dominant component of the majority of Australian investors’ portfolios (~60%). Core portfolios aim to provide an index plus return profile with a medium risk profile (between 50-120 stocks and tracking error of >0.50% - <3%). Based on our analysis, less than 25% of Core portfolios have delivered >1% above the ASX 200 Accumulation Index (Index) after fees.
  • Concentrated: Concentrated strategies tend to look very different to the index holding between 20-30 stocks vs. the index with 200. An active approach to investing that aims to deliver significant excess returns with a higher risk profile (tracking error 4%+).

The chart below shows both the historical and our forecast (based on the current environment) distribution of assets across the three broad approaches to investing.

Source: Macquarie Investment Management research and forecasts

As can be seen above, based on our research, the majority of managed assets (~60%) are currently held in Core portfolios. However, over the last few years data globally shows a trend towards a flatter distribution. More specifically, both passive and concentrated portfolios are increasing share at the expense of Core portfolios.


Why are Concentrated managers winning assets?

We believe there are three key reasons why investors are transitioning from more traditional Core allocations to Concentrated managers:

  1. Performance – In short, Core portfolios have not delivered on an after fee basis. As illustrated below, the median Core manager has on average delivered at best index returns on a post fee basis. The median Concentrated manager has fared better, outperforming the Index on an after fee basis over both three and five years. Table three shows that the Macquarie High Conviction Fund has delivered returns significantly above the Index and the median Core and Concentrated managers over one, three and five year time periods.

    Table One – Median Core Manager

    Years*Excess Return
    (post fee)
    Tracking ErrorInformation Ratio
    (post fee)
    1 Year -1.37% 2.02% -0.68
    3 Years (p.a.) -0.11% 1.77% -0.06
    5 Years (p.a.) 0.09% 1.69% 0.05

    *As at 31 December 2016. Post fee performance of the Fund as at 31 August 2017 over 1, 3 and 5 years is 6.09%, 10.30% and 6.89% respectively. Past performance is not a reliable indicator of future performance.

    Table Two – Median Concentrated Manager

    Years*Excess Return
    (post fee)
    Tracking ErrorInformation Ratio
    (post fee)
    1 Year -2.78% 6.65% -0.42
    3 Years (p.a.) 0.52% 5.42% 0.10
    5 Years (p.a.) 1.00% 5.31% 0.19

    *As at 31 December 2016

    Table Three – Macquarie High Conviction Fund

    Years*Excess Return
    (post fee)
    Tracking ErrorInformation Ratio
    (post fee)
    1 Year 2.67% 4.38% 0.61
    3 Years (p.a.) 7.59% 4.97% 1.53
    5 Years (p.a.) 4.14% 5.46% 0.76

    *As at 31 December 2016

  2. Over diversification – Traditionally, Core equity funds invest in between 50-120 companies. Conventional thinking is that more stocks reduce stock specific risk i.e. the risk of one stock’s poor performance dragging down the performance of the whole portfolio.

    Research shows that 93% (source: Elton & Gruber) of stock specific risk can be eliminated by holding 20 stocks. Each stock added to the portfolio beyond this is expected to have minimal impact in terms of reducing stock specific risk. As a result the additional stocks held by Core portfolios are not considered to benefit investors as logic might suggest. Instead a Core portfolio tends to not only hold an investment manger’s best ideas, but also their mediocre ideas and a number of risk mitigating positions. This in turn leads to the sub optimal risk return outcomes outlined in the table above.

  3. Significant assets under management – It is generally accepted that significant assets under management can make it more difficult to implement a strategy by imposing certain costs and impediments such as liquidity constraints, potentially higher transaction costs as well as the need to ensure adherence to the strategy. With ~60% of all equities assets invested in Core strategies, successful managers have raised large amounts of assets. In Australian equities, such Core managers have raised in excess of $10bn. Assets of this size typically contribute to returns that are not dissimilar to the index.

    Clearly the above is not restricted to Core managers. Managers of any style require a disciplined approach to capacity management. The Macquarie High Conviction Fund utilises framework based on a percentage of the market capitalisation of the index to determine capacity.


Building a portfolio with conviction

Most investors know the age old saying – don’t put all your eggs in one basket. As a result many invest in three to five Core managers. However, instead of being rewarded for diversifying their portfolio, they are unlikely to outperform the Index while paying active fees.

To prove this point let’s assume an investor could pick three Concentrated managers or three Core managers, how would they have fared? To answer this question we ran 5000 simulations by picking three random managers (equally weighted & rebalanced monthly), then tracked the portfolio return series since 2009. The results of these simulations can be seen in the table below.

MIM Simulated Manager Model. Excess Returns versus the ASX 200 Accumulation Index. Manager data sourced from Mercer Insight Long Only Australian Equities Managers Universe. Past performance is not an indicator of future performance.

Table Four – Average Risk vs return of Core Multi-Manager Portfolio simulations
Selecting three Fund managers at random for each of the 500 simulations

Core
YearsReturnExcessTracking ErrorInformation Ratio
1 Year 10.03% -1.58% 1.33% -1.19
3 Years (p.a.) 6.69% 0.09% 1.21% 0.07
5 Years (p.a.) 11.81% 0.13% 1.04% 0.13

*As at 31 December 2016

Table Five – Average Risk vs return of Concentrated Multi-Manager Portfolio simulations
Selecting three Fund managers at random for each of the 5000 simulations

Core
YearsReturnExcessTracking ErrorInformation Ratio
1 Year 12.38% 0.52% 2.12% 0.25
3 Years (p.a.) 8.21% 1.47% 2.32% 0.63
5 Years (p.a.) 13.59% 1.67% 2.72% 0.61

*As at 31 December 2016

The data shows that a blended portfolio of Core managers is likely to revert index after fees. However, this is not the case for a portfolio of Concentrated managers. Table five above shows that over all time periods the information ratio (measure of risk adjusted returns) remains high.

Taking the analysis a step further, below we show the range of potential outcomes for an investor that allocated $100k to both a portfolio of Core and Concentrated managers over 10 years (as at 31 December 2016). We look at the outcomes for investors allocating to high performing (95th Percentile), median and poorly performing (5th percentile) portfolios.

Source: Macquarie Investment Management. Past performance is not a reliable indicator of future performance

Table Five – a selection of three concentrated managers

ConcentratedCore
5th percentile (worst) $214,196 $212,955
50th percentile (average) $242,852 $221,235
95th percentile (best) $285,472 $236,830
Macquarie High Conviction $334,933
S&P/ASX300 (Index) $227,470

*As at 31 December 2016. Past performance is not a reliable indicator of future performance.

The charts/table above reflect the following:

  1. The median Concentrated portfolio outperformed the market over the time period
  2. The median Core portfolio did not outperform the market over the time period
  3. The high performing Concentrated portfolios delivered 49% in excess of the Core portfolios
  4. Concentrated portfolios potentially offer a wilder ride with a broader range of potential outcomes.

What's clear from the above is that if investors can identify high quality Concentrated managers the reward can be substantial.


Can investors identify high quality concentrated managers?

We believe researchers and consultants in the Australian market are high quality and have displayed the ability to identify quality managers. In our view, to do so effectively requires focus. Just as we use focus on identifying a small number of companies that we believe will outperform, the data above shows that an investor should focus on identifying high quality Concentrated managers. Under this framework, we suggest an investor should spend more time identifying high quality Concentrated managers, as over time they have the potential to add more value to a client’s portfolio.


Conclusion

The debate between active and passive investing has been around for more than 20 years. However, the discussion has intensified recently as many core portfolios have delivered index like returns with active fees. In light of this, we believe it is helpful to reframe this debate, with a focus on the decision between Concentrated and Core investment approaches. Given the data and historic performance, we believe this thinking has significant merit. We suggest high quality concentrated managers, have been able to deliver returns that are significantly in excess of the benchmark on a post-fee basis and investors have better opportunities through a concentrated approach.

The big challenge then becomes can investors identify high quality managers?

What is clear is that if investors can identify high quality Concentrated managers the reward can be substantial.