The Evidence-Based Investor

Active less risky than passive? Yeah, right

Posted by Robin Powell on April 18, 2017

It was Barry Ritholtz who coined the phrase “the daily firehose of bullshit” to describe the output of the asset management spin machine. And, goodness me, we’re being well and truly blasted with the brown stuff at the moment.

A good example is the way that, to divert attention from all the evidence that actively managed funds are not worth investing in, the industry tries to associate index funds with risk.

It happens all the time. Yesterday, for example, after a report on the active versus passive issue on BBC Radio 4, the studio guest, Gervais Williams from the Miton Group, effectively pooh-poohed the story by changing the subject to risk. “The whole point about passive funds,” Williams told listeners, “is they’re largely disinterested in portfolio risk.”

On the same day, WealthManagement.com published an article with the rather alarming headline, Is the Passive Indexing Craze the new Tulip Bulb Mania? It was written by Don Schreiber Jr, CEO of WBI Investments. “In bear markets,” Schreiber warns, “passive products can fall just as much as the index, often as much as 50% or more, as we saw in 2000 and 2008. It’s time for investors and their advisers to pause long enough to remember those catastrophic losses.”

These sorts of comments make for great clickbait, but they are, in fact completely disingenuous.

All investing involves risk, whether you invest actively, passively or somewhere in between. Indeed, there is a direct connection between risk and return. The more risk you take, the higher the return you can expect to receive, and the greater the volatility you are likely to have to endure along the way.

Active funds are just as risky as index funds, if not more so. The simple fact that they cost far more greatly increases the risk that they will underperform, net of fees. They also include fewer stocks, so when one or more of those stocks plummets in value, the impact on the fund’s overall value is greater. And then there’s manager risk — in other words, the danger that the manager of the fund will fall ill, say, develop a drink or other personal problems, or simply move to a different fund.

Yes, index funds will rise and fall in line with the market, but active funds will generally fall about as far as well, if not even further. In cases where they don’t (and, of course, those of the cases we always hear about), it’s usually not down to manager skill but the simple fact that most active equity funds also contain an element of bonds or cash or both.

The idea that active managers somehow possess magical expertise that makes them immune to the normal laws of risk and return is down to PR and marketing. The myth of “downside protection” has been repeated so many times that it’s become an accepted fact.

Every investor, regardless of whether or not they index, must feel comfortable with the level of risk they’re taking. If you feel you’re taking too much risk, you should apportion more of your portfolio to bonds or cash.

But don’t be fooled into thinking that using active funds will somehow limit the risk you’re taking; in fact, you’ll simply be adding to it.

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Robin Powell

A journalist and broadcaster, Robin Powell is a campaigner for positive change in the investing industry. He runs a communications company for the evidence-based investing sector called Regis Media.

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