Week Five – Level Three approaches

We wrote in one of our first articles heading into the lockdown that perhaps history will yet record Covid19 as a warning, a shot across our bow to remind us to be more vigilant, to be prepared. One thing I was not prepared for (but perhaps should have been), was the price of oil. I never imagined in my life that I would ever see the price of oil go so low as to find it cheaper than air.

Where to from here … well, the world relies on oil. One day it may not, but today, this simply reflects these very uncertain economic times in which we live. Cheap oil is going to help the recovery, but the effect as you can see, is beyond anything our modern world has seen. It will rise again.

Despite oil, Financial Markets have continued to hold that ground recovered from the lows of March 2020. The speed and strength of that recovery has been a surprise. There is an increased risk that if adding more weight of capital, this could drag us lower faster, should conditions shift. So once more, it’s a timely reminder to cautiously push forward, questioning again time frames and tolerance, because investing is personal, and in that regard - if comparing strategies, we need to be sure to measure like for like.

I had a dear client email me earlier in the week, after reading a financial advice column, igniting the active vs passive management debate once again:

Dear Tony, I usually read Mary Holm's financial advice column in the Herald on a Saturday - she's pretty sensible, I think. Today there was a letter giving a re-run of the active- versus passive-management funds argument. She is a great proponent of passive funds, so was not too impressed by the correspondent's "only" minus 13.5% drop in the first quarter (with Milford). That she says is about the average for actively-managed funds. Her passive fund man that she quotes had only a 10.6% drop. Sooo... I went and looked at my portfolio performance for the first quarter and...10.06% down! So, we beat even her reference point. Well done, Tony -and thank you! Cheers B.

It sounded like the article focused on performance and that’s usually how this conversation about “active” or “passive” goes. Let’s face it, performance is important. If we’re investing for the short-term, gains are less critical as most people are more concerned for the return of capital, than the rate of return on capital. In the short term, the rate of return is nearly always secondary.

Long term, performance is far more important and so we accept degrees of risk in exchange for a superior result. However nearly all of us are guilty of measuring performance well before the race is done. We may not cut from a position (measure twice, cut once), but we may retrace our steps and very often, depending on the short-term result we’re seeing, we may be driven to make changes. I recall a particular Hare and Tortoise race, where one opponent started measuring too early, resulting in an over-confident position, which saw their race end badly.

So, how long is “long”? Suddenly this is a personal question, because it really is different for everyone. As a personal financial planner, it’s normal to invest with a long-term intention, but it’s not uncommon that something else comes up; a new house, a new car, a trip, the kids, the parents, a health issue. Remember retirement? Suddenly, that structured, long-term pool of liquid funds is cashed up in part or full to accommodate a new goal. That action will almost always have a performance effect, but it’s a future return consequence that investors don’t feel now, so they’ll tend to ignore it. So, what’s all that got to do with passive indices or active managers? Well, it’s all part of the larger machine.

I tracked down the above-mentioned Mary Holm Herald column, and it was pretty good, it spoke a lot of New Zealand’s managed funds and passive markets. To be fair to Mary, there is just too much context and detail to capture in these forums. The truth is, New Zealand’s Share Market is incredibly inefficient. Fact: A2 Milk and Fisher & Paykel Healthcare make up 20% of our market!! That’s not efficient. I’ll say no more about that today and welcome discussion. We like both and neither looks cheap – but…

In an efficient market, passive indices have the privilege of keeping the same series of securities in place, to reflect a particular group – and it’s always fully invested. Humans are seldom that disciplined. Active, relies on people and in the long - long term, “active” tends to run out of history. Warren Buffett would be one of the most known managers, with the longest history (54 years), but the Financial Markets themselves will outlast any active management group, even with capable successors. And just as I’m doing today, data will confess to anything if properly tortured. Speaking of which, the last fifty years Buffett’s return has been 20%p.a, the comparable index was 10%p.a. He is exceptional – and not alone.

If we can measure like for like and if we’re talking about “efficient markets”, then in my assessment passive must ultimately beat active - but it relies on a whole series of assumptions and time. Humans change things up because, things change. If we invest in an active manager who’s just following the index, then more fool us (we could buy the same index for 1/10th the cost). But perhaps the active manager gives something that the passive index does not. The index is cheap for a reason.

It’s seldom just about performance and investors have different reasons for investing. A very simple example would be so-called "Ethical Investments".

An index (passive) fund, does not care if it includes armaments or tobacco (if it does, then it starts to find itself on a slippery “active” slope). That said, we can buy passive funds and build them into an active portfolio (i.e. medical or infrastructure related indices for example). But we have no input over the components of an index, we’re just passengers. To have some control, we have to be active. I think we can find a manager more culturally aligned to what we want, or we can just DIY – actively and passively.

In conclusion. Our world is changing and we would not drive forward using the rear-view mirror.
Index investing can be a little like that - as can “active” investing. To my mind, adopting both a passive and active approach makes sense. On average, if we’re never distracted through being human and we take a long-term stand, then 70% of the time the passive approach will likely beat the active approach. Massive big exceptions exist. Like for like is difficult and diversification continues to be the only free lunch.

We will continue to commit to businesses we feel confident about in the long term, in managers who think logically and position prudently and in active & passive. Investing is a complex thing and, it’s personal.

Tony Munro | CFPCM, Post Grad Dip. Bus.Studies (PFP), AFA, FSP 5501

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