The active-versus-passive debate is once again back in the limelight with the news this week of low-cost passive provider Vanguard’s launch of new website for personal investors. This simply adds fuel to the flames: figures from EPFR suggest that in the past 12 months, passive equity funds have seen global inflows of $442bn, while active funds have seen outflows of $534bn. It therefore seems reasonable to ask what the future looks like for active management.
My view is that the answer may be rather different depending on the area of the market being addressed. My starting point is, naturally, the familiar territory of UK smaller companies. Given the low levels of liquidity and market efficiency, it strikes me as a challenging environment for passive approaches, but does this play out in practice?
As far as I can ascertain there is really only one product marketed as a ‘passive’ UK smaller companies fund. Professional courtesy dictates that I refrain from naming names, but I think it is worth highlighting some of its characteristics:
- It is not really a smaller companies fund
It is managed against the MSCI UK Small Cap index which includes constituents with more than £5bn of market capitalisation. This compares to most active funds using either the Numis or FTSE Smaller Companies indices with maximum market caps of £1.8bn and £0.9bn respectively.
- It is not a fully passive product
It uses an ‘optimised’ tracking process which involves holding selected index constituents rather than all of them.
- It significantly underperforms the index it aims to track
The fund underperformed its benchmark in each of the last five calendar years by an average of 88 basis points. Meanwhile the median UK smaller companies fund returned 16.7% p.a. in the five years to April 2017 compared to 15.0% for the Numis index against which the majority of them are run.
- It charges high fees
The fund advertises a Total Expense Ratio of 0.58% – far above the typical level for passive products.
Much is made of the failure of active funds to beat their benchmarks. My guess is that this kind of research is almost always targeted at the big global indices (starting with the S&P 500). In the small-cap world there is a broad, fragmented opportunity set that creates inefficiencies for active managers to exploit through fundamental analysis and stock selection. Variable levels of liquidity meanwhile make passive strategies challenging, especially at scale.
While never complacent, I am not ready to hand over my stockpicking duties to an algorithm just yet!