There are active manager styles which consistently beat the market: the trick is knowing where to find them?
The decision to adopt an active investment stance over a passive stance has been debated extensively for decades. While, at the asset class level, equities offer superior returns to cash, bonds and property over time, investors aim to beat the market and capture even more than the average equity return.
However, research shows that globally, over investment periods of five, ten or even twenty years, about 75 percent of investors fail in their quest to beat the equity market. By extension, only a modest 25 percent of active investment managers are successful. This result suggests that for most investors, a passive investment is the correct decision.
Such an investment aims to replicate a market or index?s performance as closely as possible. A passive portfolio will usually track a market index, such as the FTSE JSE All Share Index or the Dow Jones Industrial Average, but they can also aim to mimic an investment theme or environment. For example, one can track European Financial Equities or Large Cap Asian Equities. (Ironically, it can therefore be argued that a decision to be a passive investor is an active investment decision.)
By contrast, an active investor will set out to beat a pre-determined index. Some active managers employ a particular style in this pursuit, while others may make use of sophisticated quantitative tools or better-than-average research capabilities. In all instances the active manager, through the belief that markets are inefficient, is trying to outperform a particular index.
Evidence clearly supports passive investing
While the evidence is in clear support of passive investing, it is not without its shortcomings. By simply replicating an index?s performance or characteristics, no attention is given to forecasting or subjective assessment. For instance, if one were to construct and manage an index of high dividend yielding shares, it would take into account only historical information: no attempt would be made to determine whether those dividends will increase, decrease or stop altogether. Unrefined or raw tracking of a market index will be overweight in growth, high momentum and large-cap stocks. Of these factors, only momentum has been shown to have any merit in terms of future success.
All investors who choose active investment management do so with the belief that they fall into the 25 percent of those investors that beat the market. Different strategies are used in this task. They include a top-down or bottom-up approach, a belief that one can time the entry and exit point of markets and stocks or perhaps that a purely quantitative investment process is most successful. Different active investment strategies provide us with examples of successful practitioners. However, while the likes of George Soros, Warren Buffett and Benjamin Graham have focused on different strategies, and have proved successful investors, the evidence for active investing in aggregate remains damning.
That active investment managers fail to beat the market is a mask which conceals the fact that certain styles of investing can consistently outperform the indices. In Eugene Fama and Kenneth French?s study of 1998, they examined the quarter of active investment managers that do beat the market. The results revealed that some styles consistently beat others, one of them being the value philosophy. The depth of this result is of importance too. The value style showed to be successful across markets, geographies, time, currencies and companies. Importantly, it is not an effect of investing in small companies, but delivers success across companies of varying sizes.
A value investment philosophy can deliver significant outperformance
A value investment philosophy can deliver significant outperformance of both the growth investment philosophy and the market. However, long term market-beating performance by the value style is not without interruption over the short and medium term. The difficulty with adhering to this style is that, most often, value investing opportunities are unpopular and unloved stocks. By contrast, most people follow loved and popular stocks which are by definition high growth, high momentum, and large capitalization shares. As stated earlier, of these factors only momentum offers any evidence of success.
Since the market is the sum of all activity taking place in it, you need to be different to the market, or contrarian, to enjoy market-beating results. However, most people follow popular and fashionable shares and so three quarters of investors fail to beat the market. Following a value style can require nerves of steel as the short and medium term deviations from the market?s performance may be difficult to tolerate. For those who are unable to step away from the comfortable stance of 'safety in numbers', a passive fund is the correct place to be. For the rest, there is active value.
Andrew Newell is Head of New Business at Cannon Asset Managers