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Fast food (passive) vs restaurant dining (active)

Chris Meyer

Pinnacle Investment Management Limited

Food and investing. Strange bedfellows in a Livewire piece. Or maybe not. COVID lockdowns have catapulted both. According to Nielsen research, Australians are spending 70% more time on food and cooking websites since before COVID. We're all becoming 'foodies'. On the investing front, Robinhood, the pioneer of commission free trading in the US, listed on the Nasdaq this week disclosing they had 22.5 million stock traders as its customers, double this time last year. We're all becoming investors. This wire looks at another food analogy for investing, making the case that passive investing is like eating fast food - cheap, convenient and reliable but mostly ends up tasting the same. Active investing on the other hand, is more like restaurant dining - more expensive and not always better than fast food, but can offer a unique taste and a memorable experience for those who do it excellently, and there are many. 

Livewire has brought the active vs passive debate out of the attic in the last few weeks with their panels on LICs and ETFs, most recently here. Fair enough given it can often be a confronting choice for investors given the lobbying power in the media of both the active and passive industries fighting their respective corners. This wire tried to provide a simple way of thinking about the difference. 

The passive zealots give two clear reasons for why they should "win". The first is cost. Can't argue there, passive is cheaper, and everyone loves cheap. Be careful though, most passive funds will underperform their benchmark after fees and slippage (it's not that easy exactly tracking an index). Think of that - 100% of passive managers underperform their benchmark ! The second reason given is that on average active managers don't beat their benchmarks so why bother trying to pick the winning active managers. As one zealot on this Livewire panel put it, it's basically "roulette". 

The most frequently used fodder given by the zealots as evidence for this is the SPIVA report (developed I might add by S&P Dow Jones, an index provider). It's actually a great report, very user friendly and free ! The best chart in my view is the one below that shows a map of the world and the percentage of active funds in each country that underperformed their benchmark over 1, 3 and 5 year periods to 31 December 2020. Eyeballing the graphic, readers can see that indeed, right across the world, it is true that ON AVERAGE, over longer periods, active managers underperform their benchmark. Two things the zealots fail to point out: 

First, perhaps 25% (nothing scientific just looking at the numbers in the chart) of active managers DO outperform their benchmark over the long term. That's still a LOT of managers (perhaps 200 of the 834 managers in SPIVA's 5 year Australian fund analysis). 
Second, you can't buy the benchmark for free. In fact the passive behemoth in Australia, the Vanguard Australian Shares Index Fund (VAS) with $8.8bn of FUM, has net performance (after fees and slippage) since inception that is 0.14% p.a. behind its benchmark. Factoring this in would make the number of active managers beating their passive equivalent (i.e. what investors could actually buy the index for) in excess of 25%. 

Encouragingly too, the one year numbers (which include the COVID market meltdown and recovery) look much better. More than 50% in Europe, 40% in the US and 44% in Australia using the same graphic below, beat their benchmarks. Given that this market "mini-cycle" is the first example in a while when active manager skill was truly tested, as opposed to the QE driven one way rise in equity benchmarks for the last 10 years, it possibly provides some evidence that active management is making a comeback. Humans can still exercise good judgement.

In general, the larger and more efficient a market, the harder it is for active managers to outperform. The below chart from Morgan Stanley's research team shows the percentage of active equity managers beating their benchmark in Europe (left chart) and the US (right chart). Three things stand out. Using these numbers it seems more like 40-50% of active managers have beaten their benchmark over a rolling 3 years. A better picture than the SPIVA report anyway. Secondly, much like the point above, performance of active managers is getting better having been at its worst in 2018. Thirdly, less efficient markets like US mid & small caps and global emerging markets have a higher % beating their benchmark than say for active US large caps.

Back to food. In many ways, the passive zealots are like fast food junkies. Fast food is cheap, it's convenient, you generally know what you're going to get and it fills you up. Fast food, however, especially too much of it, can also be dangerous. In much the same way, passive index investing is also cheap, ETFs are convenient, you're unlikely to be surprised at the outcome of your investment (positive or negative) and it gives you good access to the broader market. Passive investing and ETFs are here to stay. Indexes, however, can also be dangerous. Think of the corporate bond index. The more indebted a company (and thus potentially riskier), the higher its index weight. Or a share index, the more stretched the valuation of a share (and thus potentially riskier), the higher its index weight. Both can be passive investing dangers the zealots won't warn you against. 

Active management is more like a restaurant. It's super difficult to succeed as a restaurant owner. A quick look at the app shows there are 5193 Sydney restaurants on Tripadvisor, 483 (call it 10%) of which have a 5 star (excellent) rating by users. About 3000 are 4 star or higher (call it above average), and thus possibly better than fast food. Its a competitive market that requires a lot of hard work to be excellent. But those that are excellent enable a totally different experience to fast food. You can have that amazingly authentic taste, that sublime setting and that memorable shared experience. Similarly, excellent active asset management is competitive and hard work. It also gives you access to different investments. Private equity, private credit, infrastructure and physical real estate won't be found in an ETF. Active investing can also give an investor an excellent, above average outcome. For the high conviction active manager that outperforms by 1% p.a. after fees over 10 years (entirely possible), that's 10.5% compound additional return to the investor over the index, more like 15% over the equivalent passive investment if you add in the fees and slippage when buying an index fund. That would be an amazing outcome for any investor and "taste" a lot better than any passive fast food. Such a restauranteur deserves to charge more and to succeed. 

In much the same way that most 'foodies' enjoy a combination of cooking at home, a good cheeseburger from Maccas from time to time and that special restaurant dining experience, so too do many investors like a combination of DIY investing, passive ETFs and active investing (funds, LICs and active ETFs). Just because they are different doesn't mean they can't co-exist. Yes, excellence in active investing is harder than passive investing as excellence in running a successful restaurant is harder than making fast food. As a result, on average, most don't succeed....but excellence never came easy and why only settle for average.     


 


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Chris Meyer
Director
Pinnacle Investment Management Limited

Chris is part of the Pinnacle executive management team and responsible for driving the listed products business. Pinnacle’s mission is to establish, grow and sustain a diverse and complementary stable of world-class, specialist investment managers

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