The problem with the active v passive debate is that there is no right answer – that’s why it’s a debate. Everyone’s got their own opinion.

It’s also a very emotive subject. People believe their opinions are “correct” and will cling to their existing beliefs.  To change is too big a leap – a step into the unknown. But that is exactly what I did – and I’m still around to tell the tale.

This is my personal journey.

In order to make some sense of all the information, I needed to get back to basics. There has been so much written about actives and passives I decided it was time to try and make some sense of it all, to strip everything back so I could create some fundamental investment beliefs.

I decided that I would use an approach I first encountered during my History & Philosophy of Science lectures at university. I would not accept anything that hadn’t been shown to be the case – in published academic papers. I took my inspiration from Rene Descartes in the 17th century – only for me it was financial science. Back then Descartes decided that he would not accept anything as fact unless it had been proved.  This eventually presented him with a significant problem: he could not prove his own existence. He experienced a great deal of mental torment until he decided the only way out was via his now famous “I think, therefore I am”.  For me, back in the 21st century, when I stripped everything back I found a single question upon which the whole active v passive debate hinged:

Could someone predict the future? Not just most of the time either, I mean repeatedly and consistently predict the future.

Assuming infinite information and resources, does someone have the ability to predict which way the market (or individual stocks within that market) will go? For me the answer was no – but I had to think long and hard.

My “moment of clarity” came when thinking about the hypothetical investment manager who gets it mostly right. Why, occasionally, do they get it wrong? I came to the conclusion that they must guess it wrong.  With all the information available to make a “correct” decision they still sometimes called it the wrong way. If they guess it wrong sometimes, then surely they must also guess it right too.

There must have been an incorrect interpretation of the information. This means that decisions are being made using interpretations of the information – not facts. Opinions if you will. We all have opinions but – and you can call me old fashioned on this one if you like – I don’t think anyone should invest other peoples money based their opinions. After all if they are so good why do they need to invest other people’s money? Surely they would have amassed enough wealth of their own to spend their days investing their own fortune. There will certainly be some lucky guesses – sometimes repeatedly. But guessing it right repeatedly is not down to skill. It’s down to luck.

Once I had satisfied myself that I didn’t believe anyone could predict the future I started using a single phrase that encapsulated everything I believed: “there is no crystal ball of investing”.

With the active v passive debate decided (at least for me) I embarked on (re)building an investment philosophy based on my interpretation of the information available – that no one could predict the future. This meant no active managers and definitely no core/satellite compromise either.

The core/satellite approach is based on the belief that most active managers can’t predict the future so passives are used (core), but that some managers can predict the future so actives are used (satellites). I’m aware that this is a huge over simplification of the core/satellite approach but for us consistency is paramount. There can be no animal farm fudge for us: if four legs are good then four legs are good – end of. How can four legs be good but sometimes two legs are better?

No, for me the question was much more black or white. Can active managers predict the future? YES or NO. If YES lets use them for everything, if NO let’s not use them at all.  Either active managers can predict the future or not. Suggesting that most of them can’t but some of them can seems a bit incongruous to me.

The next step was to sort out asset allocation.

It is well documented that asset allocation can explain most (over 90%) of the variation in returns between portfolios (market timing and fund selection between them explain considerably less). We set out to find the asset allocation that is on the efficient frontier (the mix of assets classes that produces the best returns over a certain period). But there is a problem here: the efficient frontier is a historical construct i.e. you won’t know the efficient frontier for the 12 months to 31st December 2012 until 1st January 2013. That is after the end of the period.  If we were going to make calls about asset allocation to be close to the efficient frontier we were going have to do what we had already decided couldn’t be done – predict the future.

If predicting the future is futile then why try? Why not adopt a “buy and hold” approach.  Some of the asset classes within a portfolio will out perform and others under perform at different times – we just don’t know when each asset class will rise and fall. A much better solution is to maintain discipline and sit tight. If some asset classes underperfrom it’s time to sit tight. After all we couldn’t see it coming – no one could. Same as when an asset class does well, “why didn’t we invest more in it?” – because we didn’t know that it was going to do well. This is why we choose as widely diversified asset allocation as possible. And why we need to instill discipline.

But how can we decide on a suitable asset class allocation? The method we selected was based on an often overlooked part of modern life – common sense. We chose an asset allocation that “just seemed to make sense”; Fixed income to reduce volatility (i.e. no high yielding bonds – risk and return are related) and equities to deliver long term returns. Of the equities about 10% are in global property (zero or negative correlation to equities during periods of volatility)  and of the remaining equities about half in the UK and a big chunk international equities. The remainder goes into emerging markets so as to have an exposure to capture some of the up side but to limit some of the downside. Doesn’t change, ever. Is it on the efficient frontier? – PROBABLY NOT. Is it going to be quite close every year? – PERHAPS. Is there excessive trading each year trying to chase the ever changing efficient frontier? – NO.

Once the decision to accept that no one can predict the future has been made then the use of a tactical asset allocation overlay gets consigned to the dustbin too. If you think about it for a moment you see how absurd it is. Why are we able to make predictions about future asset allocation performance and correlation but other people can’t. When we do it it’s skill, when they do it it’s luck. Misguided at best, deluded at worst.

For me this journey took a while and forced me to really question my beliefs. As a result we now have a robust and consistent investment philosophy, based on published academic evidence and tempered with common sense and discipline. It is easy to explain, it is easy to understand and it is easy to implement.  This enables us to protect our clients from the 3 biggest destroyers of private investor wealth:

Not being sufficiently diversified

Trading too often

Selling low, buying high

Our clients are protected from these wealth destroyers because we don’t pick stocks, we don’t pick managers and we don’t try and time the markets. That’s one of the ways we help people make smart decisions about their money.