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Market Review: September 2009 Commentary

Peter Lynn brings back the debate that I first encountered when I returned to New Zealand in 1998.  Is active management worth the higher fees than passive investment? This is a more straight forward debate now that the tax incentive has been removed for New Zealand passive investors. Helen McKenzie, Tyndall.

Tuesday, September 8th 2009, 11:28AM

Active vs Passive: The Debate Is Back
During the latter half of the 1990s, in particular, there raged in the New Zealand investment management community a vigorous debate over active and passive investment.  Although the hoary old chestnuts of "the average active manager does not beat a passive manager" were brought out repeatedly, the debate basically came down to one issue: tax.

In fact, my phrase "vigorous debate" is a slight exaggeration, because a situation was created that made it almost impossible to debate against passive investment.  You see, for those who do not remember or were not in the industry at the time, on 11 June 1996, the New Zealand Stock Exchange launched their listed TeNZ fund, covering the top 10 stocks in the New Zealand market (now known as an "exchange-traded fund" called SmartTENZ).  Because the fund invested in these top 10 stocks passively (and hence was forced to buy and sell stocks whenever the index weights changed), the fund applied for and acquired from the IRD a binding ruling that saw it excluded from being taxed on capital gains.  Remember, at that time, investment funds paid tax on all capital gains as well as income.

Once the IRD had set this precedent with TeNZ, all other passive New Zealand equity funds followed suit and gained similar binding rulings.  Now this created a hurdle for active managers to surpass, just so their investors would receive the same net return level as the passive fund investors.  Over the period from 1 July 1996 to 30 September 2007 (when the PIE regime removed taxation of active capital gains), the NZX 10 Gross Index rose 8.5% p.a.  However, the average gross dividend yield was 6.5% p.a. over this period, so only 2.0% p.a. was capital gains. 

Therefore, if an active and a passive investor generated exactly the same returns after fees, the passive fund had an advantage of 33% on the 2.0% p.a. capital gain, or 0.66% p.a.  This 0.66% p.a. was the hurdle that an active New Zealand equity manager had to surpass after active fees before it could be at the same level as a passive New Zealand equity fund.  In fact, over that period from 1 July 1996 to 30 September 2007, the average active manager in NZ returned 15.0% p.a., comfortably achieving that outperformance hurdle.  In fact, all those who survived to the current day earned over 13.6% p.a. over that period.

The playing field, though, became far less level when the IRD granted a similar binding ruling to AMP's WiNZ fund, which was a passive global equity fund.  AMP's rationale was, quite rightly, that the fund was transacted in exactly the same way as the New Zealand passive equity funds so should be treated the same on a taxation basis.

The main difference between New Zealand and global equities is that dividend yields are significantly lower in global equities than domestic equities.  That difference was probably at an extreme in the late 1990s.  Over that same period, 1 July 1996 to 31 March 2007 (when the FDR regime removed the taxation of capital gains), the MSCI World Index with net dividends reinvested (so not including withholding taxes that are unable to be reclaimed) returned 7.8% p.a. in local currency terms (local currency means US stocks in US dollars, UK stocks in sterling, etc).  Of this, a staggering 6.2% p.a. was in capital gains, leaving only 1.6% p.a. in net dividends.  To now grant that 6.2% p.a. a tax-free exception created a hurdle of 33% x 6.2% or 2.0% p.a. for active managers.  This was also after the fee differential between active managers and passive funds.

In New Zealand actuarial surveys, unhedged NZD returns tend to be used to quote manager performance in global equities.  On that basis, the MSCI World index was 7.4% p.a. over that period.  The average active global equity manager in New Zealand returned 9.4% p.a. - pretty good (2% p.a.  better than index, which is a common outperformance target), but not quite at the level required to offset the tax hurdle after the higher fees that active managers charge.  Fortunately, the dichotomy that had been wrought between active and passive managers was removed with the taxation changes in 2007.

In the past few months, though, demand for passive funds is on the rise again.  This is a global phenomenon and this time, in New Zealand at least, it has nothing to do with tax.

The horror of 2008's investment markets and disappointment from a small number of active global equity managers (mainly those few who purchased financials when they became "cheap" and watched them fall even further) has caused many investors, particularly trustees of superannuation funds and charities to decide that the "safe" thing to do is to move to a passive manager for global equities.  Investing in a passive manager (which usually costs less) mitigates the risk of active manager underperformance.

Well, passive investing does mitigate that risk, but it also carries with it a large opportunity cost - the chance of active management gains.  One rationale given recently is that investment markets for the next few years are likely to be on the rise.  The thesis continues that active management gains aren't as "important" in up markets (as both passive and active investors share in the gains and, anyway, what's a couple of points extra in a double-digit rise?) That thesis, though, will be completely blown out of the water if the market suffers a fall in the final quarter of this year and weakness throughout 2010, possibilities that are slowly gaining some traction as people wonder about the world after the stimulus packages have been worked through.

Active investing is at its best in weaker markets.  A good active manager (only good ones should be appointed) should be able to wade through the heavy waters of falling or weak markets and avoid the stocks that fall the most (as indeed many active managers did during the past 18 months).  In this regard, active managers are actually a much safer option than passive managers.

Passive managers are completely at the mercy of the indexes they follow.  Indexes are dominated by the performance of their largest stocks, which determine the rise or fall of the passive funds that invest in them.  As an extreme example, imagine you are in passive global equity fund in the 1980s.  As the decade progresses, Japanese stocks take up a larger and larger proportion of your fund.  By the end of 1989, they comprise 40% of the index and hence of your portfolio.

By the end of 1990, those Japanese stocks are nearly half of the value they were at the start of that year.  The poor passive investor must simply watch the fund value fall in line with the index.  An investor with a good active manager should have been able to avoid the large performance drop by underweighting Japanese equities as their valuations became more and more stretched.  Because passive funds rise and fall in line with the index, they are actually more volatile than actively managed portfolios.  If your idea of risk is volatility, then an active portfolio is less risky (and thus possibly more safe) than a passive fund.

The actual theoretical basis for passive investing is not particularly strong either.  Passive investing has its roots in Harry Markowitz's Modern Portfolio Theory, which uses as a basis the Capital Asset Pricing Model.  This model states that all investors need is a combination of a risk-free asset and an efficient portfolio, with the weights of that combination being determined by the level of risk the investor is willing to take on.

Over the years, most have assumed that the "efficient portfolio" is the index, linking it in with the "efficient market hypothesis" that all securities reflect all known information and, ultimately, render active management as luck or "randomness".

Don't be fooled.  The weak form of the efficient market hypothesis actually says that a stock's price is composed of the probabilities of all future events - the actual outcomes may be different.  Stronger forms of the efficient market hypothesis are routinely discredited by market behaviour itself (especially during bubbles and their bursting).  Further, Markowitz himself has said that he never stated that the "efficient portfolio" of Modern Portfolio Theory was meant to be the "efficient market" (an index).  The portfolio itself had to be efficient, which means there is not another portfolio of a similar risk level that will offer a higher return.

So, investing in an index is not necessarily the most efficient way of achieving global equity (or any other asset class) exposure.  If markets do not strongly track upwards, it can be significantly more volatile than active management and often lower returning.

As for that old chestnut that the average active manager does not perform as well as an index fund, it is possibly true.  But then you don't want an average active manager anyway, do you?

Peter Lynn, CFA
Head of Strategy
1 September 2009

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