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Why Active Investing is Not Optimal

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Why does active investing not outperform a passive approach in most investment scenarios?

I have a few thoughts on that.

Efficient Markets

Most financial markets are pretty efficient. Perhaps not 100% strong form efficient (where all public and private information is reflected in the security’s price), but relatively close.

Of course, the efficiency of a particular market is a function of many factors. These include: the number of investors and analysts in the marketplace; regulatory and governmental oversight and reporting requirements; the sophistication, availability, and timeliness of relevant information; the type of asset and the quantities available for trading.

Depending on these factors, an individual market will be more or less efficient.

Do not blindly assume that all markets, even those in the same county, will have the same level of efficiency. If you want to trade equities on the New York Stock Exchange, the market should be quite efficient. If you plan to trade penny stocks over-the-counter (OTC), the OTC market will be less efficient than New York.

Markets will typically be less efficient in developing countries and in niche markets. If you wish to invest in North Korea, the markets will be less efficient than in North America. Markets for investing in emeralds or Renaissance art will not be as efficient as financial markets.

This is why I think active management is possible in small or developing markets or other areas where these factors are more difficult to achieve at a high level.

I believe that most major financial markets, for the most part, are close to strong form efficiency. An exception would be during extreme periods that take on a life of their own. Investment bubbles [4] are a classic example of this.

If financial markets are near strong form efficiency, it is extremely difficult to use active investment techniques to outperform a benchmark. So why try? Take a passive approach that will approximate the benchmark return. It will take less time and energy, and you will have less stress in your investing life.

Active Management Costs

If the financial markets are relatively efficient, then it should be hard to beat one’s benchmark with active strategies.

Adding to the problem are the incremental costs associated with active management.

A passive strategy assumes a buy and hold approach. An active strategy will have greater trading. This creates additional transaction costs and may possibly trigger taxable capital gains for investors. Both of these will erode one’s net returns versus a benchmark.

Further, if you pay for active management, there are fees for that service. Depending on the mutual fund company and the investment style, these can vary significantly between funds.

For example, consider the U.S. equity market. As at September 30, 2010, mutual funds in the domestic large blend equity classification averaged 1.13% per annum in total expense ratio (TER). For world stock funds, the TER averaged 1.52%. Given that the returns for the S&P 500 (a good benchmark for U.S. large blend stocks) and the MSCI World Index returned 10.16% and 7.29% respectively over the previous 12 months, it requires some impressive management to outperform the index benchmarks with an average TER.

Remember our discussions on compound returns [5]. You want to minimize your expenses [6] in order to maximize the capital that can be reinvested for long-term compound gains.

Paying management fees and increased costs while not normally seeing enhanced net performance is another reason you should consider passively investing.

Good Active Funds Eventually Become the Market

Over time, successful actively managed funds run the risk of becoming the market.

As a mutual fund grows in size, its ability to find unique and profitable opportunities in the market diminishes.

Say you are an excellent stock picker and decide to start a small equity fund investing in Canadian stocks. You raise $10 million in capital and begin to invest. Your initial focus is on companies with less than CAD 50 million in market capitalization. These nano-cap [7] companies are not heavily followed by analysts nor investors and the market is less than fully efficient.

Over time, your fund demonstrates superior performance against your chosen benchmark, the S&P/TSX Composite Index.

The superior performance is noticed by investors and subscriptions to the fund grow. One day you wake to find you are managing CAD 1 billion. By this point, it is almost impossible not to have become the market itself. You can no longer realistically invest solely in nano-cap stocks.

At a maximum of CAD 50 million capitalization, and at most acquiring 5% of any one entity, you would need to spread your capital amongst 400 or more companies. As we saw previously, this is a problem logistically as well as in transaction and administration expenses.

Further, by having to spread your capital so thinly, the impact of any one stock is very small. If you equally own 400 different companies and one produces a 100% annual return, its effect on total portfolio performance is negligible. Unless you can find a majority of companies with superior returns, the total portfolio performance will regress to the market average.

One could also argue that if you own 400 or more nano-cap stocks, you probably reflect the nano-cap market as a whole in returns. You are now the Canadian nano-cap market.

More likely though, you would be forced to adjust your investment strategy and begin to place your capital in companies with larger capitalization. Companies where you are able to invest millions of dollars without having a material interest in the company.

When assessing actively managed funds that have experienced significant asset growth, always closely review recent performance. The strong performance that led to new investors and increased assets will likely regress to the market mean as the old strategies no longer work to the same extent.

Avoiding Becoming the Market

Some fund companies try to avoid these growth problems in two ways.

One, they start a new fund with limited capital so that they can invest in smaller markets without logistical concerns. Of course, if the new fund also grows, they will face the same problem in the future.

Two, some companies may close the growing fund to new subscribers. By placing a limit on the fund’s capital, the fund can maintain its strategy in the small market. Note that a fund that temporarily suspends new subscriptions is not the same thing as a closed-end fund [8].

Conclusion

Except in limited situations, I hope you will agree that actively managing your investment portfolio will not produce superior performance versus a passive approach.

So what investments should you look at with passive investing?

We will outline that next.