Passive vs Active Investing
This story highlights some considerations when looking at active versus passive investment management. In 2008 Warren Buffet (considered by many to be one of the world’s leading investors) issued a challenge to the hedge fund industry.
He would invest in an index fund, in this case a Vanguard fund based on the S&P 500 index, which tracks large cap US shares. The hedge funds would invest in 5 of their “best” funds. The bet was a million dollars to charity and the bet was taken up by hedge fund manager Protégé Partners. The bet was essentially a bet of active management (Protégé) v passive index management (Buffet).
Source: http://kerrfinancial.ca/buffetts-bet/
The chart above shows the results to the end of 2015 and with the S&P index up 12% at that time. Now we know there are always some active managers that outperform and this is partly just the law of averages so if you take a sample of anything some will be above average and some will be below.
So why is it so hard to pick managers that outperform over the long run? Well there are many reasons, but two big ones explain most of the results:
- Active Management has a cost
The cost of active management can be 1-2% higher than passive management. For a hedge fund with their even higher fee structures, the cost can be as high as 3%. So investors in these active funds that get a return after fees start off well behind the index.
- Behavioural bias
Humans are predictable in that when we are looking for funds that will outperform we tend to look only at funds that have recently outperformed. This is an example of recency bias, where investors put too much faith in recent results.
The challenge here is that to outperform, a manager must take some risks and make some calls. Over time they will get some of those right and some wrong. In nearly all cases they will go through periods of outperformance and underperformance.
Here is the problem though. Investors seeking to outperform usually put their money in active funds AFTER they have outperformed and often take their money out AFTER the fund inevitably underperforms as all funds eventually do.
And where do they put their money after they have pulled it out? Yep you guessed it, in another fund that has shown recent outperformance, thus starting a vicious cycle that will lead them to massively underperform the index in the long run.
You could call this the performance paradox, which is the paradox that chasing performance actually leads to underperformance in the long run.
A long term investment strategy where the bulk of the investments track the index and have low costs, ironically will lead to above average performance in the long run.
This is compounded even more when investors have confidence in their strategy and avoid chopping and changing and stick to their strategy through the combination of a long term plan, based on your owns needs, risk tolerance and ongoing regular advice not only on the investment strategy but also on managing the behavioural biases that we all have, particularly when the markets are going through volatile times.
Now it’s not over yet, Warren Buffet and Protégé Partners have 1 more year remaining in their challenge. Why not check on your investment strategy and see how you are tracking?
General Advice Warning - This communication has been prepared on a general advice basis only. The information has not been prepared to take into account your specific objectives, needs and financial situation. The information may not be appropriate to your individual needs and you should seek advice from your financial adviser before making any investment decisions.