Professional advisers and investors are under more pressure than ever to give up on managers who carefully pick stocks. They are encouraged to opt instead for cheaper funds that simply track an index (like the FTSE 100). It is estimated that more than $30bn was pulled out of actively managed funds in the first six months of 2019 alone.
It is not surprising when you see studies showing that over a decade as many as 86% of actively managed funds underperform.
Proponents of passive investing often point to Nobel Laureate Bill Sharpe’s ‘Arithmetic of Active Management’1 as irrefutable proof of its superiority. Sharpe argued that the investment market amounts to a zero-sum game – one investor’s gain is offset by another’s loss and the market return equals the average returns of all participants in aggregate. This means the average actively managed pound will generate the same returns as the average passively managed pound before costs, but less once the higher costs of active management are factored in. It is simple maths.
In a world of ever-increasing passive investment, we believe the potential benefits of sensible, long-term active investment are greater than ever. We recognise some of the strength of passive investing but believe that by replicating some of the things the index does well and improving what it does poorly we can tilt the balance of probability of outperforming in our clients’ favour with active management.
Passive investing – strengths and weaknesses
First, we recognise that passive index funds benefit from a number of advantages that make them difficult to beat. They can be owned very inexpensively and there are few changes made within the index over time, keeping trading costs low. Large-cap index funds by definition also hold their winners.
But, like all investment strategies, index funds have weaknesses too. They take no notice of fundamentals, such as valuation, business quality or cash flows. So at the turn of the millennium they would have had no way of avoiding structurally impaired companies like Kodak.
In the late 1970s Eastman Kodak accounted for more than 90% of photographic film and 85% of the cameras sold in the US but filed for bankruptcy in 2012 after failing to keep pace with the development of consumer digital cameras and smartphones.
Index funds can also lead investors to hold dangerously overvalued shares like Cisco in 2000. In March that year, at the height of the tech bubble, Cisco briefly became the most valuable company in the world, with a market capitalisation of $500bn – over 200 times its earnings at the time. The shares fell by 80% over the next 12 months, and the company’s market capitalisation today remains 65% below its 2000 peak.
“In a world of ever-increasing passive investment, we believe the potential benefits of sensible, long-term active investment are greater than ever.”
Indices also suffer from occasional episodes of considerable capital misallocation. This can lead to previously strongly performing sectors accounting for an overly large proportion of the index, setting investors up for an uncomfortable return to reality. The technology sector in the late 1990s, the banks in 2008 and the mining sector in 2011 provide salient reminders of what can happen when investors extrapolate, overlook or even dismiss fundamentals.
Replicating the strengths
Reasonable management fees combined with low turnover can help mitigate some of the index’s main cost advantages; our focus on building portfolios with a significant proportion of long-term direct equity holdings helps us reduce both ongoing operating charges and portfolio turnover. We are not afraid to hold onto our favoured investments, with several companies present in client portfolios since our inception in 2010.
Avoiding the weaknesses
One of the advantages of active management is that we have a keen interest in company fundamentals. A wealth of academic studies has shown that valuation has a significant impact on future returns. David Dreman’s Contrarian Investment Strategies2 analysed investment returns of the 500 largest US companies between 1970 and 2010. Dreman found that the cheapest 20% of stocks (rebalanced annually by the popular price/earnings valuation measure) outperformed the market by 3.7% a year and the most expensive stocks underperformed by 3.2%.
Of course, valuation is not the only consideration when looking for attractive investment opportunities. GMO, a global investment management firm, conducted a study into long-term stock performance, which found several factors that persistently added to returns over long periods, including low debt, high profit margins and consistent earnings3.
When identifying potential investments, we focus on companies with robust balance sheets (low debt levels), high market share and sustainable competitive advantages (typically leading to high profit margins) combined with a business model that results in a high proportion of predictable or recurring revenues (delivering consistent earnings). We believe these types of companies are best placed to continue to outperform the index over the longer term.
What is more, when used in combination with a commitment to buying shares at sensible valuations from the outset and then keeping them, we believe we have a template that significantly increases our odds of outperforming index returns over the long term.
Posted on 27 November
1 Sharpe, W.F. (1991) The Arithmetic of Active Management. The Financial Analysts Journal. 47 (1), 7-9.
2 Dreman, D. (2012) Contrarian Investment Strategies. www.dreman.com/about-dreman/the-potential-advantages-of-a-contrarian-strategy/
3 Joyce, C. & Mayer, K. (2012) Profits for the Long Run: Affirming the Case for Quality
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