One of our portfolio managers recently published a column in The Australian Financial Review on the contentious "active vs passive" investment debate, which you can download for free here (or read via the AFR here). The column opened as follows:
"Buying a "passive" or "indexed" fund is lobotomised investing, predicated on the beliefs that the market is smarter than you are, investors are systematically rational, assets are always properly valued as prices move in an unpredictable "random walk" and, finally, one has no ability to identify those "active" managers that do consistently beat benchmarks. (Yes, they exist.) The problem is that every single one of these assumptions has at various times and across different sectors proven to be wildly incorrect, save for the question on your relative intellectual quotient and/or financial markets expertise. For those who never want to engage in analysis and/or are convinced they possess fundamentally inferior faculties, passive strategies may certainly be preferable to an "active" approach. And let's be frank, many folks fall into this category. Yet let's also bust the utterly misguided myth that passive investing is universally superior to active."
For many, if not most, the financial market reaction to President-elect Trump’s stunning victory would have been shocking. How on earth could US equities be up 1.1 per cent—an amazing 6 percentage points higher than the lows immediately after the result when the S&P500 smashed into its negative 5 per cent “circuit breaker”—and government bond yields be above their pre-election peaks after dropping like a stone? The answer resides in expectations of President Trump contrasted against “stump Trump”.
We don't think Australian bank shareholders are cognisant of the risk that if equity capital ratios fall modestly, there are new automatic restrictions imposed by the regulator on the distribution of earnings that mean dividends may not be paid. In fact, it is likely that some banks will stop paying dividends altogether in the next recession as they rebuild capital eroded by loan losses.
At a seminar this week I was asked to define what we mean by "active" management. Start with the alternative: passive investing or blindly following market indices is by design price- or valuation-agnostic capital allocation (given the assumption markets are generally right or "efficient"). Irrespective of how overvalued or undervalued an asset class may be, the passive portfolio accepts exposure to it.
In theory the most attractive solution to mitigating these hazards is focusing portfolios on "active" strategies that produce bona fide "alpha": that is, risk-adjusted excess returns that are unrelated to "beta" or the day-to-day movements in mispriced markets as represented by "passive" indices (the ASX/S&P200, for example). This is akin to finding a very cheap house – perhaps offered by a vendor who has to sell quickly because he or she has committed elsewhere—that rewards you with capital gains that have nothing to do with general house price inflation.
There are several important take-aways from the Australian Prudential Regulation Authority’s excellent new study on the major banks’ capital. Winners are depositors, senior and subordinated bond holders, and the regional banks. Losers will likely be shareholders and investors in the majors’ hybrid securities.