Those who argue against the value of active equity management have been feeling pretty good lately. Their beliefs about the superiority of a passive approach have been gaining more and more acceptance, to the point that the idea of indexing a large part of an equity portfolio has become conventional wisdom. In particular, large cap equities are highlighted as an asset class so efficiently priced that it is practically impossible for an active manager to add value.

We are certainly interested in discovering the truth behind this debate, can any manager deliver meaningful excess returns over the long term? Is it possible that market dynamics have permanently changed, such that we now face long odds against outperforming? Or, on the other hand, have there been natural, explainable and cyclical factors that have led to the recent outperformance of passive indices, such that the case against active is only a rationale for chasing performance? We take a critical look at the arguments against active management and why they are being embraced today. In doing so, we hope to offer some insights that may allow investors to profit from questioning conventional wisdom.

Not so good timing

The active versus passive debate is just one of many popular investment discussions. Read newspapers, magazines, academic papers, or watch any investment programme on television, and you will get a regular dose of authoritative-sounding arguments for the superiority of a particular investment approach: long-only vs. long/short, regional vs. global, quantitative vs. fundamental. It seems that all camps have compelling arguments backed by long-term data to support their views.

We have always been sceptical of these definitive, one-size-fits-all investment decrees. While it may not make for exciting headlines, we believe in the simple idea that different environments favour different investment approaches. Because the market moves in cycles, tailwinds for one style, asset class or manager will represent headwinds for another. In other words, managers may seek to exploit different pockets of market inefficiency, so that the timing of achieving excess returns may also be different. While many market commentators seem intent on proving the superiority of one approach, we believe most investors would be better off replacing versus with and, recognising that there is room in a portfolio for both active and passive, as well as fundamental and quantitative, etc., and so benefiting from diverse sources of alpha.

Another reason we are sceptical of these definitive investment statements is that they are often embraced by investors at the wrong time. While academic arguments for passive investing have existed for decades, we are afraid that their popularity today is based on recent experience. As figure one demonstrates, over the past several years active managers across all equity styles and market caps have failed, on average, to outperform their respective benchmarks.

Figure one: Ranking and annualised return of various benchmarks (2003-2006)

Figure two: Ranking and annualised return of various benchmarks (2000-2002)

Using US large cap core equities as an example, figure one shows that the S&P 500 would have ranked in the 21st percentile of the Large Cap Core Lipper category (outperforming 79 per cent of managers) and returned 14.7 per cent annualised over the four years ending 2006.

Here is where the problem of timing comes into play. Todays conventional wisdom that we referred to earlier generally sounds something like this: because the average active large cap equity manager has underperformed the index over time, investors should get beta exposure in this area via index funds, futures or ETFs, and seek excess returns through exposure to exotic beta (emerging markets, small caps, high yield) and the alpha generated by alternative investments like private equity and hedge funds. And this is indeed wise advice especially if it was followed five years ago. However, figure two shows the environment that investors experienced five years before this.

In this time period, we see the opposite of the 2003-2006 environment. Not only did active managers generally outperform, but equities experienced a bear market, with the S&P 500 down -14.6 per cent annualised over three years (nearly 40 per cent on a cumulative basis). The point is, at this time investors wanted nothing to do with beta, let alone exotic beta, appreciated the downside protection active management provided, and were willing to sign up for single-digit absolute returns. This drove demand for fixed income and market neutral strategies.

Indeed, buying fixed income and market neutral strategies was a good idea were it made three years earlier. Of course, at the end of 1999 there was the new paradigm, and investors wanted long-only equities, the more tech-heavy and momentum-oriented the better.

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