(Sept 11): There are plenty of narratives in the matter of active versus passive investing. I, too, have discussed this issue at length here, in the past.

Fact: Investors are abandoning actively managed funds for passive ones. The record amounts currently invested in exchange-traded funds (ETFs) will testify to this.

Active fund managers certainly do themselves no favours through years of under-performance and failing to justify their fat fees. We have compiled returns for unit trusts and the numbers are hard to dispute.

If you recall, we shared some results a couple of weeks back (“Balanced funds: Not so balanced”, Issue 793, Aug 21) and will share more in the near future. To be fair, one could argue the underperformance in recent years may be cyclical, though globally, empirical evidence suggests this is not the case.

On the other hand, passive investing is far from being a no-lose proposition even though low fees are a permanent advantage over active management. For starters, if you buy the market, you cannot hope to beat the market. Furthermore, simply replicating the index without consideration of the underlying fundamentals of companies is mindless and, in my view, will have severe consequences eventually.

Is robo-investing — an algorithm-driven portfolio (based on a set of rules) — the answer? Can this strategy minimise both fees and risks? The fund management industry appears to think so, offering more and more products that tout “smart beta” investment strategies.

In layman’s terms, robo-investing is translating characteristics used by active managers to select stocks (earnings, cash flow, dividend yields, gearing and so on) into a fixed set of rules governing trades instead of simply following a traditional market capitalisation-based index. The goal is to convert the alpha (of active management) into beta (still passive investing, cost-effective and transparent).

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We tested this proposition using the methodology outlined in the table.

For both Malaysia and Singapore markets, we constructed five portfolios based on different rule sets, including Fundamental and Valuation scores from AbsolutelyStocks.

The results: All five portfolios in Malaysia outperformed the FBM KLCI ETF benchmark, but only one outperformed the STI ETF in Singapore.

Still, it’s early days yet. The portfolios are only two months old in Malaysia and one month old in Singapore.

Investing based on fundamentals (quality companies) is a strategy for the longer term and requires some patience.

Or it could be that we are not that smart. We can admit that.

I rather suspect, though, that while quantitative analysis can do a lot of the heavy lifting, success still requires the human touch.

The theory of rational expectations and efficient market hypothesis says as much. Market valuations (prices) are based on the collective wisdom of expectations for the future, that is, the best guess using all available information. Therefore, no formula-based (using historical information) trading rule can earn excess returns and beat the market over a sustained period of time, and not without taking excessive risks.

In short, strictly algorithm trading is probably unlikely to work. Plus, who is to say that the people setting the rules are any smarter than underperforming active managers?

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<i>Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore</i>

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