The debate over active and passive management
Given the recent flows that passive investments have received, it might seem that the debate between active and passive has been resolved. Exchange Traded Funds (ETF’s) have grown from approximately 100bn USD in the early 1990’s to over 3trillion USD today. But every dog has its day, and markets will always ensure that active managers will have their time in the sun once more. What’s more, we question whether the debate is an over simplification – do investors simply face such a binary choice? Is there a middle way?
In the red corner….
Passive investing means in essence a buy and hold approach to investing – a deliberate attempt not to outperform a given benchmark, but to simply accept and replicate its performance as cost efficiently as possible.
Assets have poured into passive strategies over the last decade, with passive funds tallying inflows of nearly $4 trillion between 2010 and 2020. This compares to outflows of $185 billion from active funds over this period. If the trend continues, passive funds may soon overtake active funds in total global market share.
Active management by definition seeks to outperform a given benchmark, either via market timing or identifying individual stocks or securities that drive outperformance in the portfolio.
Exhibit 1: Copturing total return - asset allocation
Source: ARIA, RBC
The History of Passive Investing
The first index based fund was launched in 1976, although to little fanfare. By the turn of the century, indexing was in full flight and passive portfolios using vehicles which tracked a given reference index or market segment had gained huge popularity.
Those who subscribe to the passive approach are able to draw on fertile ground to make their arguments, including substantial evidence of underperforming active managers. In fact, there are a multitude of studies that show the active management rarely justifies the fees. For example, S&P Dow Jones Indices produce a report each year and it doesn’t make good reading for those pushing the merits of an active approach. Its annual SPIVA institutional scorecard, reports that over the 10 years ending 31st December 2016, in the large-cap equity space, 84.60% of mutual fund managers and 79.58% of institutional accounts underperformed the S&P 500 on a net-of-fees basis. When measured on a gross-of-fees basis, 68.16% of large-cap mutual funds and 69.20% of institutional accounts underperformed.
Some proponents of passive investing have even gone as far as to draw a straight line between socialism and active management. The fall of the USSR and other communist states goes to show, as the line of argument has it, that the market is the best means of allocating resources – relying on mister market, rather than an active intervention on the part of a central planning body (or manager in that light). That’s perhaps a stretch as a metaphor, but goes to the heart of the question as to whether active management can deliver value.
The Convenience of Capital Market Assumptions
Moreover, when clients’ advisers are charged with building a financial plan, one that arrives at a certain destination or monetary value for a given investing pot, there needs to be an ability to rely upon certain return estimates or assumptions to do so. A purely passive approach allows the adviser to use historical market returns, which can be complicated by an active manager who may deliver returns that diverge from historical returns. Of course, such historical assumptions of a given market returns are only averages, and often rely on minimum holding periods that exceed most investors’ time horizons to be statistically valid.
What then are the arguments for active management?
Of course, given both sides are so well entrenched, there’s a statistic for every narrative. Just as passive investors point to numerous studies, there are other academic approaches that do support active management – at least muddying the water somewhat. In general, such studies highlight the cyclicality of out or underperformance of managers relative to the benchmarking peers. That’s to say that there are often periods of outperformance of active managers, but they are habitually specific to given market environments.
A rising tide floats all boats
Perhaps unsurprisingly it is more volatile periods that active management can prove its worth. In fact, when market returns are over 10% per annum, one third or so of active managers beat their benchmarks.
Active Managemnt Tends to Flourish in Tough Markets
Percent of Managers Beating Benchmark
As of December 31, 2016 Historical analysis does not guarantee future results. Measured by the average annual outperformance of active managers in the Large Blend Morningstar category vs. each fund’s primary prospectus benchmark over the past 20 years.
Source: ARIA, IEA.org
However, during periods when there aren’t such tailwinds, active managers outperformed – more than 50% of them. Moreover, the degree of outperformance is highly correlated with exactly how active the managers were. Those ‘true stockpickers’ who had the highest degree of divergence from their benchmarks, delivered the greatest outperformance.
This is all intuitive – when markets are beset by calm, then prices for companies should reflect their intrinsic worth. However, as soon as uncertainty strikes, the emotional nature of stock markets takes hold, prices swing in both directions and create significant potential divergences from their inherent value. It is at those points, such as in the build up to the Global Financial Crisis, where certain active managers may foresee the coming storm, sidestep the ‘market’s worst punches’ and deliver significant outperformance. Perhaps therein lies the essence of sustainable outperformance – not so much of outperforming on the upside, but doing so by preserving capital better than the stock market may do during downswings.
It's worthy of note that many studies that undermine the value of active managers, really consider those funds that are ‘closet trackers’, and not seeking to take much by way of active bets away from their benchmark.
One of the principal drivers of the passive movement is the minimisation of the fee stack for the end investor, to maximise their lot to the detriment of the industry. That in itself is a noble aim, and reflects the ‘disintermediation’ trend that has characterised all industries in the last decade, ‘just in time’ business model which searches for ultimate efficiencies. At the time of going to press, it’s arguable now that an ‘equilibrium point’ has been reached whereby many actively managed approaches are comparable, if not cheaper that some of the management fees charged by the more esoteric of ETF’s available.
But there is only so much fat can ultimately be trimmed before compromises are met. As consumers globally are ever more informed, they will demand more from their investing portfolios – more surgical ESG exposures, more precise allocations to emerging markets. For example, in the current geopolitical environment, its feasible that investors will demand where they do take on emerging market exposure, it does not include certain geographies will may increasingly be at odds with western governments. EM ETF’s ex China, Russia or perhaps even India are more expensive to offer and by definition less passive by nature, requiring a more active involvement.
The FANGs may yet prove to be venomous in their own right. We would wager that many investors who hold US ETF’s were not necessarily conscious of the significant concentration the ‘market exposure’ held in just four or five stocks – the Amazon, Apple, Facebook (Meta), Netflix and Google accounting for approximately 20% of the market . Moreover, their dominance disguised (whilst dramatically improving), the wider performance of the US stock market. That concentration has already perhaps driven significant underperformance in US indices compared the FTSE 100 in 2022.
In an environment whereby a rising tide floats all boats, there is less marginal benefit in choosing stocks, emphasing sectors or highlighting geographies. The dominance of tech stocks in a period of historic low volatility left little reason for investors to go beyond a simple indexed portfolio approach. Yet the convenience of such approach may prove less rewarding in years to come. As markets may be challenged by higher interest rates, business cycles may be more ‘boom bust’ in nature akin to those of the 1970’s, the operating results of businesses will increasingly diverge. A rising tide is more likely to transition into cross currents, and selecting your boats very carefully (to those which still retain pricing power), may be fundamental to driving positive returns. Disintermediation is a powerful trend, and the ‘end investor’ increasingly taking the reins of their own asset allocation is logical outcome. And in doing so, generic indexed products may not prove to be customised enough for an increasingly well educated investor.
Conclusion: Truth in the Numbers
As a company, we can never ignore the macro and moreover we seek to look for the nuance. In order to validate other work, we have undertaken our own research into active management over enduring periods. By overlaying the rate of change of volatility, unveils some interesting developments. In line with other studies, we have determined that during periods of higher volatility, as measured by the VIX index, which can be considered a proxy for investor uncertainty, active management delivers its best results.
Percentage of Actively Managed Funds Outperforming S&P 500
Source: BLOOMBERG, ARIA.
And therein perhaps shapes the debate in a more considered fashion. When markets are in periods of relative stability, it is more difficult to outperform the indices. Markets are a human construct, the old chestnut is to ‘sell high and buy low’, but if there isn’t significant variation in stock markets, there is limited opportunity to outperform. Active management inherently needs volatility – periods when investors are emotionally driven and overact to conditions where variables such as inflation, interest rates or economic growth, diverge from investors’ expectations. It is the opportunity that the fog of uncertainty creates, for a handful of skilful managers, who are able to peer through the mist and make a clear headed determination, where passive investors are beholden to the emotionally driven by market gyrations. An interesting question is that did equity markets, such as the FTSE 100 when registering 3465 on March 6th 2009, reflect the prospective earnings prospects of the coming decade, or did the stock market at that point in time reflect a view of the world which was largely dominated by what had gone before in the financial crisis?
Therefore, which camp to join? Both approaches play a role in keeping capital markets orderly. We feel that the lines of this particular debate are poorly drawn. The choice perhaps is regime dependent. Determining which regime the market may be in at any given point in its own right could be a role for a professional practitioner. We prefer to adopt a pragmatic position and embrace both approaches to investment management. We explicitly offer both within our suite of portfolio strategies.
Of course, the decision to employ either active or passive techniques, should consider an individual’s circumstances, their asset base, experience and tax situation. We would encourage a more pragmatic approach, one that recognises that certain market regimes can reward both active and passive approaches contingent upon the market environment. Perhaps less contentious is the matter that most would find common ground in the notion that markets are cyclical. In that respect, we believe that being on autopilot in an era of what appears to be structurally higher volatility, even if it is just for this part of the cycle, is to accept some of the potential losses, that a passive approach unapologetically positions for. The munificence of central banks ushered a period of great calm and moderation in markets, however, the onset of such extreme inflation now means that they are beating a retreat, taking the punchbowl away from the party, and with it, the relative serenity that has been such a notable feature of financial markets in recent years.
Therefore, it is reasoning such that higher interest rates will likely widen the difference between stock market winners and losers, the prospects of having seen peak profit margins may favour stock pickers, the sheer size of the ETF industry may sow the seeds of their own challenges and that lower growth environments can create a ‘winner takes all’ stock market, means as a minimum we want to retain the ability to actively steward client assets, rather than feel hamstrung and compelled to accept stock market results come what may.