Passive versus Active Management: A False Dichotomy
Eran Peleg, CIO May 3, 2017
2016 was a record year of inflows into index-tracking, passive, funds -- over $430bn -- and the share of US equity assets held through ETFs and index funds rose to more than a third of the total, thus doubling their share over the past ten years.
It is not a coincidence that one of the most heated investment debates today centers on active versus passive investing. Passive strategies usually come in the form of index-tracking exchange-traded funds (ETFs) or mutual funds, charge lower fees and aim to obtain the performance of an underlying market index. Active strategies will charge a higher fee and will be expected to outperform market indices over time, typically through active security selection. Active managers have been around for a very long time, while the passive investment market started to develop in the 1980s/1990s1 and really took off in the past 10-15 years.
Asset Flows to Index Funds
Source: Morningstar, Strategic Insight Simfund
At Clarity, we do not see the active versus passive management debate as an all-or-nothing choice. Any argument that presents it in this way is using a false dichotomy to give an impression that the two approaches are mutually-exclusive. Those using such arguments are either ignoring important aspects of either active or passive investing, or may be motivated by particular self-interest (‘talking their book’). Both passive and active strategies have particular advantages and disadvantages that need to be taken into account. Moreover, these need to be considered from both strategic and cyclical perspectives. However, as wealth managers allocating client capital, we believe that both approaches have roles to play in investment portfolios – and our approach combines active and passive strategies.
What is our strategic thinking about active versus passive? We follow a few basic principles:
1) There is room for both passive, index-tracking, and active strategies in wealth portfolios.
2) Passive ETFs and funds are effective as low-cost asset allocation tools and can be instrumental in achieving broad diversification at low cost, especially in the generally-efficient public equity and bond markets2. In addition, country/sector-specific ETFs can be used as an efficient way to express a short to medium term tactical views.
3) Active managers can play a role when allocating to less-efficient markets/sectors – where there is more room for active management to generate excess-returns (e.g. small-cap equities or emerging markets) – or when considering alternative strategies with differentiated return and correlation patterns (e.g. hedge strategies). Active managers should run high-conviction, concentrated, portfolios or have sector/country specialization – otherwise, their chances of beating the market benchmark are low.
4) However you combine active and passive strategies, you need to actively manage risk at the portfolio level. This is particularly important for portfolios with heavy allocations to passive strategies. Passive strategies are indifferent to risk in that regardless of economic/political/market events, they maintain, by definition, constant market exposure. Overall portfolio risk must be monitored and managed.
From a cyclical perspective, in the past two years, active managers have had a particularly difficult time. Not all active managers underperformed, but the majority of them have. For example - according to J.P. Morgan3, only 32% of active equity managers outperformed their benchmarks in 2016. Recent active manager underperformance has many aspects to it, but two prominent ones are:
1) Active managers tend to outperform when the dispersion of security returns is high (and correlation of returns is low) -- hence allowing for unique insights to be used into the investment process. This has not been the case in recent years. Having said that, in recent months, asset correlations have fallen significantly, creating a market environment that is more conducive to active management.
2) In rising markets (particularly, strong-rising ones), it is more difficult for active managers to keep up with market indices (this can be partially explained simply by ‘cash drag’ – their tendency to maintain cash balances while market indices are cash-free). It is important to note that, on the flip side, in down-markets, when the importance of risk management becomes more apparent, active managers tend to outperform. In 2016, US markets ended the year up despite meaningful risk events such as the Brexit vote and US elections – and anyone conducting risk management suffered. Passive strategies, indifferent to risk, outperformed.
Asset Correlations Have Collapsed
Source: Bloomberg, HSBC
To conclude, there is room for both passive and active strategies in wealth portfolios. Each has its respective merits and shortfalls. The skill lies in combining them in a thoughtful manner into a comprehensive wealth strategy that can yield value to clients over the ups and downs of a full market cycle.