Active or passive, that's the question

By TONY SAVAGE*

Active fund management leads to poor returns. Two factors - costs and a lack of diversification - cause investors in actively managed funds to receive less than the potential returns offered by the sharemarket.

Every year, direct costs eat up as much as 5 per cent of returns. What's more, when fund managers do not diversify sufficiently, returns are reduced even more by not taking advantage of all the gains the sharemarket has to offer.

Investors actually pay many managers to underperform, using vain efforts to buy undervalued shares, waiting for better times or taking bets on a small number of shares. Yet research shows the expected return on this type of speculation is zero.

In fact, independent research has thoroughly discredited the sales pitches used by the active management industry.

At the heart of the matter is the fact that most managers lack the motivation to change. It is difficult, after all, to get a person to do things differently when the corporate culture demands - and their salary depends on - sticking to the status quo.

Looking for "undervalued" companies based on the managers' own "research", betting on sectors and industries because of economic "predictions" and switching funds for "tactical" reasons all rob money from the investor.

These strategies work only as a huge fee earner for their proponents and entertainment for the mass media.

So how should an investor choose managed share investments? Is past performance the best way to choose which manager will win?

Consider how often managers repeat a winning performance. Not often. The odds of picking a manager that outperforms the market by 1 per cent or more reduces to about one in 14 over just a few years.

Choosing how to invest in the sharemarket requires careful detective work by you or your adviser.

For the investor who does not fully diversify, the cost is huge. The perennial underperformance of active managers soon leads to half as much money as might have been achieved - and twice the worry.

Investors lose money in the process of active share trading compared with the investor who invests only once in an internationally highly diversified share portfolio.

The research is clear - underperformance of New Zealand managers by as much as 5 per cent a year penalises an investor with $500,000 capital by $25,000 each and every year.

To make consistent and higher returns on the sharemarket, do less active trading. Although your sharemarket returns won't be much higher than someone who is actively buying and selling shares, having your funds simply work away in a fund that is not active means you will do just as well on average but with the added benefit that it costs less.

It is this saving that provides the smart fund investor with consistent long term, overall higher dollar returns.

If a manager's skill is to diversify widely at the lowest cost, then the financial adviser's role is to ensure the investor can afford to stay invested.

Predictions of the level of future returns require an exceptionally accurate crystal ball. An even more accurate one is required if active management strategies are to pay off. Mostly they do not and the investment detective should largely disregard them.

Returns occur by staying invested in the sharemarket at all times. The keys are a disciplined assessment of individual needs and circumstances, planning and education.

The theory of investing is simple: buy shares from every company in the sharemarket and pay low fees. Implementing the theory is hard, and requires considerable focus and a great deal of discipline that is not compatible with active management.

For traditional equity fund managers, the behaviour of the sharemarket drives nearly all of the returns an investor will receive. Capturing nearly 100 per cent of the sharemarket return is an achievement earned only rarely and inconsistently by active managers.

The numerous ways investment product peddlers have devised to fool investors are remarkable only for their breadth, variety and persistence. The investor who fails to educate themselves pays a high cost in the form of an underperforming portfolio.

Return has little, if anything, to do with the skill of an investment manager. Costs are a good guide to the level of underperformance you can expect - low costs mean better performance. The worst funds charge high fees - management, administrative, trading, taxes and selling fees - because they have to pay salespeople a lot of money to sell them.

Investing is a complicated endeavour. To sum up, fully diversifying by owning shares from across the sharemarket and holding onto these shares forever is the ultimate strategy for winners.

Beating the market is a loser's game.

Choose an adviser you can trust, who maintains a consistent story about the relationship between risk and return in varying markets and discloses all the costs that you pay.

* Tony Savage is research director at Strategic Asset Management, a private banking firm that provides wealth management services for clients including private and institutional investors.

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