A question that often comes up in the discussion between active or passive investing – a subject we have touched on a few times throughout this year – is can you time it? Are there certain periods where active as an aggregate should outperform passive?
As investors in both active and passive strategies, we would argue that active exposures are most viable in circumstances where:
- There is a clearly inefficient market (e.g., emerging markets)
- A highly specialised skillset (e.g., derivatives, niche debt products)
- There is a hard-to-access factor or style (e.g., concentrated value managers)
- There is sufficient potential to gain benefits of diversification within a universe
Notice there that there’s very little consideration to timing in these examples – timing implies that you are seeking one broad view of active versus passive, where we believe portfolio construction should focus on the utility added by a strategy rather than its classification.
But to digress, let’s examine the “can you time it?” question through the example of broad equities exposures, a staple of most portfolios and certainly the subject of timing discussions, given the broad availability of passive indexes tracking large cap indexes like the ASX 200 or S&P 500. Could a fee-conscious adviser time the switch to a large cap Aussie active exposure from an index ETF, and vice versa?
Well not to jump immediately to the conclusion, but the answer is “no, because a broad active index hasn’t sustainably outperformed passive for two decades” …
A similar scenario exists for global equities:
Certainly, we can see that there are cycles every 1-2 years where active performance will mean revert close to active, but over a rolling basis neither broad collective of managers has managed to sustainably deliver a premium over passive exposures.
This is for an entire universe of active managers. What if the timing was between passive and top-performing active instead?
It’s all very well to assume that one can reliably pick a top-performing manager, however we’ve also recently talked about how difficult it is to find persistent outperformers.
Instead, we’ll take a simple and objective approach; a potential investor picks out the top three global large cap managers from the Morningstar universe, based on their past performance as of 31 October 2022.
Can the top three managers, ranked by 3-year returns, outperform passive in such a sustainable manner that you could time a switch into them?
With the potential exception of Fund #2, this example seems to be consistent with the idea that these active managers are either close to or below the performance of passive on a rolling 1-year basis, offering very little opportunity for an investor to time a switch into a broad active mandate.
What about over 5-year returns?
Again, besides one fund, there were very few opportunities where attempting to time a broad exposure would have yielded an investor a meaningful spread over passive in the past 15 years – and even then, the spread mean reverted so quickly that the churn in client portfolios would be unpalatably high for most investor preferences.
To add a disclaimer to this discussion, we have seen through empirical experience and our own analysis of performance data that most manager performance is mean reverting, relative to an index or benchmark.
The point here is not to argue that you should pay no consideration to performance (or valuation) when timing your allocations, nor that active can never outperform passive – rather we argue against solely trying to replace a passive exposure with similar active mandate simply to try and time some kind of arbitrary active premium.
Returning back to our own internal considerations for active management, always consider what role a particular exposure has in the broader context of a portfolio; are you making a strategic view, based on evidence and a sufficient time horizon, or are you trying to time a future you don’t know for certain will eventuate?
Whilst we believe the former will always keep you in good stead in the long run, the latter dramatically increases your risk of ruin and often adds unnecessary churn to a portfolio.