The Active vs Passive Debate

Australian Private Capital, over many years has observed that ‘Passive’ investment management tends to deliver a better long term return than ‘Active’ investment management. But why?……

Daniel Kahneman, Professor of Psychology at Princeton and winner of the 2002 Nobel Prize in economics probably said it best. “The idea that any single individual without extra information or extra market power can beat the market is highly unlikely. Yet the market is full of people who think they can do it and full of other people who believe them. This is one of the great mysteries of finance. Why do people believe they can do the impossible and why do others believe them?”

How about Warren?

Another interesting perspective comes from Warren Buffett who has made the point many times that high turnover, expensive managed funds (such as hedge funds) would under-perform relative to low cost, simple passive index funds over a long-time period. Warren Buffett has taunted hedge fund managers, saying that a simple low cost index fund (e.g. the S&P500 ETF) would perform better over the long run (10 yrs) than more expensive hedge funds. In fact he challenged anyone to take a bet with him that this would be the case. Buffett expected a parade of fund managers to come forward and take the bet… and “defend their occupation”. What followed was “the sound of silence”. One manager finally came forward and made a $500,000 bet with Buffett. Ted Seiders of Protégé Partners, selected a basket of 5 hedge funds to compete against Buffett’s choice, the Vanguard S&P500 ETF over a 10-year period. The bet began on 1 January 2008 and is now into its 9th year. And the results have been very interesting as the table below outlines:

The returns from the simple passive index fund have significantly outperformed the hedge funds. A $1million dollar investment in the basket of hedge funds would be worth around $1.22mill now, while an investment in the Vanguard S&P500 fund would be worth around $1.85m.

The SPIVA Report

Annually the SPIVA report is published comparing Active and Passive investment strategy performance.  A high level summary to 31st December 2016 comparing Active manager’s performance against their chosen benchmark after fees over 1, 3, 5 and 10 years respectively illustrates Professor Kahneman’s point.

      1. 86%, 94%, 93% and 89% of Global Equity managers underperformed
      2. 76%, 67%, 70% and 74% of Australian General equity managers underperformed
      3. 82%, 62%, 48% and 33% of Australian Small/Mid cap managers underperformed
      4. 63%, 90%, 77%, and 88% of Australian bond managers underperformed
      5. 77%, 93%, 83%, and 77% of A-REIT managers underperformed

The full report can be downloaded here.

Can you know which sector will shine, before the dawn?

It is difficult to see how one could know which sectors will do best relative to others sectors when you look at the following table.  Each sector has its own colour (the second table) and the performance from best to worst is arranged top to bottom (the first table).  To suggest there is a pattern is a real stretch! 

So, can you beat the market?

Evidence over long periods of time suggest the answer is yes, by taking a semi-passive investment approach and keeping investment costs low.  By semi-passive, what APC means is structuring your portfolio to tilt to the sectors which we know, from evidence, do better than the overall market.

Academic research has identified these sectors of securities that have delivered higher returns (or premiums) over time. These premiums may be positive or negative in any given year.  Over longer periods, historically the expectation of positive premiums increases. Structuring your portfolio to target these sectors helps increase the reliability of outcomes.

So what are these sectors?

Company Size

Smaller companies tend to deliver a superior return over larger companies over the long term.  This is because Risk and Return are related. However it is important to understand they don’t consistently deliver this premium, but if you take a long term approach, tilting your portfolio to this sector will reward the patient investor.

Relative Book-to-Market Value

Often called a ‘Value’ stock, this is where a company’s market value (ie number of shares multiplied by the share price) is lower than its book value (ie the value the accountants give the company). Value stocks have tended to outperform Growth stocks over time, though not all the time. However in the competitive ‘listed company’ world, relative underperformance to peers is not generally tolerated for long.  Either the management’s strategy changes or the management changes!  This tends to lead to a ‘re-rating’ of such ‘Value’ stocks, and the price generally goes up.

Profitable companies

It may sound obvious but a more profitable company tends to deliver superior returns when compared to a less profitable company in share price terms.

How have these sectors performed relative over time?

Australian Shares

U.S. Stocks

Developed World – Ex U.S Stocks

Emerging Markets


As you can see from the tables above, these premia are observable across all markets over long periods of time.  By ‘tilting’ a portfolio to these sectors you increase the probability that over time you will obtain a superior return to the market generally.

Australian Private Capital has implemented this philosophy over many years, obtaining for our clients returns that are superior to the market.  Our portfolios are low cost and low trading which enhances after tax returns.

If you have any further questions about APC’s investment philosophy feel free to make contact with a member of our advisory team.