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'You may see indexes going higher, but they will correct again' - Alan McChesney.

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THE DAYS of passive investing are over.

So says investor Alan McChesney from New Zealand Assets Management, who believes the world has entered a period of stagnancy for sharemarkets in which passively riding the ebbs and flows of the indices will bring nothing but disappointment.

One of the great philosophical divides in investment is whether it is better to pay low fees and invest in funds that passively mirror sharemarkets, relying on the historical trend for markets to appreciate over time, or to pay high fees to active fund managers who try to beat the market through stockpicking.

But although that debate was a live issue in times of raging bull markets, said McChesney, markets in a world weakened by the global financial crisis were not the place passive funds would thrive.

"Passive investment's effectiveness has been diminishing over recent years," he said. "But the turning point may have occurred when markets such as the S&P500 fell back to levels not seen since 1997. That meant 12 years of nil or negative returns."

That had planted a big doubt in the minds of those who plumped for passive investing, and McChesney said things would not get any better.

"There is quite a bit of research that shows the world has gone through periods like the 30s through to World War II, and again more recently where we have gone through long periods with indexes making no returns, but with a hell of a lot of volatility."

The most recent period was from 1997 to today when passive investors saw big highs and lows, but had in effect had no returns from equity.

"I don't see a significant break out of the S&P500 for the next few years. You may see indexes going higher, but they will correct again," McChesney said.

In such periods only active managers could make money for investors, and that was beginning to be recognised with a slow shift by institutional investors, such as pension funds and community trusts, from active to passive. "A number of community trusts have really been hit hard over the last few years by being passive equity investors so it has had an impact on their ability to make payments to community organisations. There is a change going on, but we are seeing more of it coming out of Australia," McChesney said. "Index investing was born in an incredible bull market in the late 1980s and 1990s and it was entirely appropriate in that period."

McChesney's belief that the world is no longer right for passive investors is based on a mixture of factors feeding into the performance of markets.

There's the demographic bubble, with baby boomers cashing up investments to spend. There's much less capital for businesses and individuals to borrow, spend and invest. There's a peaking in agricultural and technological advances.

As a result, he said, sharemarkets would go up and down but ultimately will go nowhere, and only active fund managers can offer the hope of positive returns.

McChesney might be right, but proponents of passive investing do not believe that active managers will be able to produce the returns to justify their existence.

They maintain that active managers have not shown themselves to be good at beating market returns, though in some smaller markets like New Zealand the active managers do appear to outperform the index.

John Atkinson, chief executive of Plan B, which uses a form of passive investment funds, said academic studies indicated that active managers, collectively, appeared unable to beat markets consistently.

"No one person over a sustainable period of time can beat the market. There may be suggestions there is one man [Warren Buffett] in the world who has managed to buck that, but I think even he once said `If you don't see my face looking at you then go passive'."

The ultimate reality check for Atkinson is why an active fund manager capable of beating the market doesn't just quietly amass their own fortune. "If someone is just that good why would they want anybody else's money?" he asked. "Another big issue with active is sometimes active managers get rewarded for performance which means they take bigger risks with people's money."

But Atkinson can't be seen as a fan of all passive investment. He's quite dismissive of most passive funds and agrees with the assessment that many track markets up only to track them down again, exposing investors to the volatility and amassing big costs in buying and selling shares.

"At the end of the day, I have no problem with active management," said Atkinson. "I fundamentally believe in passive management, but what I fundamentally don't like is that people don't understand the difference and the investments they are getting themselves into."

Greg McAllister from ASB Group Investments said: "There is no right or wrong answer here but it is a matter for choice for the investor or customer. I like to think of it that passive-style investments do what they say on the box, they mirror the markets and there is very little need to explain variability since you are simply getting a result from the market."

By contrast: "Active style brings variability with the potential, but not guarantee, of outperformance. Investor customers need to be prepared to take the ups with the downs and pay manager fees for results that don't always reflect the market."

But he warned: "Over the long term, in products like KiwiSaver, investors may find the added costs of active funds do not show cumulatively greater added return over passive funds."

- © Fairfax NZ News