Why we need active funds

The active versus passive debate rages on.

The passive camp points out that active funds, in general, don’t do what they are supposed to do – outperform the passive benchmark. They charge high annual management fees, even in the years they underperform. They encourage intermediaries to charge fees or commissions to select amongst them (or churn, for the really cynical). They don’t protect investors from sharp market falls. They lure investors into themes or fads that have little hope of making money. They engage in dubious marketing tactics by showing the performance of only selective well-performing funds rather than all or composite weights. They put their own profit objective ahead of their investors’. The list of apparent failures is pretty significant.

So it shouldn’t be a surprise that investors are slowly switching to passive index or exchange traded funds (ETFs). The largest of pension funds, like CALPERS, are switching. Retail investors are switching. Even the robots ie. robo-advisers prefer ETFs.

All of this is pretty well covered in the media. So I want to take the other side. While active funds also do a good job of talking up their own performance, I don’t see enough coverage of the merits of active funds as a whole, especially for retail investors. Hence, I would like to highlight a few important roles –

Active funds help allocate capital more efficiently

Passive or index funds buy stocks in the same weights as the market index i.e. by market capitalization. The larger, more expensive stocks get even more capital. The newer or smaller companies don’t get any. Indeed, they don’t even get research coverage.

On the other hand, active funds try to outperform by investing in these smaller, more innovative companies. Indeed, venture funds invest in unlisted early-stage companies. Venture/private equity and active funds investing in small cap stocks are part of the same continuum. Yes, I know there is an argument that says larger companies can also be innovative, but we will go for the more general argument that newer companies emerge to challenge the larger established ones, presumably with something more innovative. And large companies tend to buy these out and become even larger.

So active funds encourage innovation, which usually leads to more efficient allocation of capital in the economy.

Active funds help market efficiency

Ironically, active funds make the market more efficient by arbitraging away inefficiencies and unexplained stock price movements. If the price of stock rises too much, way beyond what is explained by the fundamentals, it’s the action of active investors that brings it back.

Only when active funds make the market efficient, can investors have the confidence to invest in passive funds.

Active funds can help fix broken capitalism

Passive funds have to hold stocks irrespective of the misdemeanors of the company. On the other hand, active funds can practice ‘responsible investing’. Active funds can engage with company managements to set them right (carrot approach) or play an activist role (stick approach). Some active funds have already taken the lead by signing the UN Principles for Responsible Investment and incorporating environmental, social and governance considerations into their investment process. The more investors take this approach, the more effective it will be.

Active funds with an active long-term approach, that incorporates what appear to be non-financial factors in the short-term, is an effective way we can rein in errant corporates.

So what’s the solution? Find ‘good’ active funds with good research

I don’t see the active v passive debate as black or white issue. Firstly, the case for active depends on a range of factors (such as opportunities to add value, proportion of professional versus retail investors, market efficiency etc), is different for each market and changes over time. Secondly, I believe, part of the blame lies with us for not selecting ‘good’ active funds.

Not all active funds add value to society; some simply join the ride to profit. And we’ve let them. Investors have given them money without grilling them enough about what they stand for, and how they are going to add value to investors and society. It’s been too easy for them to buy mind-space (and shelf-space) by advertising in media and sponsoring intermediaries. I am surprised by the amount of money and discussion that goes into the case for passive funds, compared to none that goes into how to do pick good active funds.

We need to take control back. We need to do better research so we only give money to active funds that have good intentions and capabilities. Let’s not conclude that it can’t be done without having tried. In my previous article, I outlined my views on why there is a dearth of good research on mutual funds. If investors agree we should implement some changes; if they have differing view, let’s hear them.

Active funds are too important to society to write off. I support active funds, but also give them a hard time as tough love. I encourage investors and advisers to do the same.

A practical way you can start is by asking your financial adviser, or mutual fund house if you are dealing directly, for independent credible research on the fund. Rating symbols (like 5-stars, AAA, Gold, top 10 lists etc) are not enough; you should ask for the investment philosophy underpinning their selection criteria and full disclosure of conflicts of interest.

Let the good active funds make you and society wealthier.

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