Active vs. Passive Investing: All the Facts

Tips & TutorialsActive vs. Passive Investing: All the Facts

Active vs. Passive Investing: All the Facts

Passive investing has active investing in a chokehold. Will it force a submission? Don’t bet the house on it just yet.
Unlike active investing, passive investing doesn’t try to beat the market; its objective is the market return. It seeks to track the movements of a representative index — whether a major stock market benchmark such as the S&P 500 or something more niche like a basket of gold mining shares. And it does so by building and managing a portfolio with the same investment holdings and weightings as that index.
Passive investing is inextricably linked to the boom in exchange-traded funds (ETFs), now a $5 trillion global business, according to industry consultancy ETFGI. These ETFs allow investors to pick which countries, asset classes, or industrial sectors to invest in –which mix of market returns to seek. In this way, passive investment vehicles are handy tools for asset allocation.
Active investing, by contrast, is more forensic; it doesn’t just pick the market, it picks the individual assets in that market and seeks outsized returns through fundamental analysis, clever trading, and general investment nous (even if some supposedly active funds are closet benchmark huggers anyway).
The highly trained, highly paid professional managers who run these funds purportedly drill deeper to gain that edge. They serve as investment curators and charge a higher fee for their services compared with passive fund managers.

Active Investing Has Struggled to Deliver

Trouble is, active investing too often fails in its aims. Not only does it often not beat the market, it can also underperform badly.
Between 97% and 99% of US equity funds, global equity funds, and emerging market funds underperformed their benchmarks in the decade to 2016, according to index provider S&P Dow Jones.
There’s damning academic evidence too.
“We find little evidence that active funds exhibit more skill than passive funds, even for top-performing funds before fees,” Alan Crane and Kevin Crotty said in a 2014 paper for the Jones Graduate School of Business in Houston, Texas, which assessed the performance of more than 2,000 funds over an 18-year period. Note the before fees.
Adding insult to poor returns, “the worst index funds fare far better than the worst active funds,” Crane and Crotty said.
Measuring a fund’s performance over a lengthy period is important because only by consistently delivering above-average returns can we genuinely differentiate a fund manager’s skill from luck. Napoleon is said to have preferred lucky generals but together they eventually met their Waterloo.
S&P Dow Jones regularly measures how well actively managed funds perform versus their benchmarks across a range of jurisdictions. Among other things their SPIVA scorecards show only 2 of 702 US domestic funds delivered consistent top-quartile performances after four years.

Fighting Back

So, if active fund managers can’t beat the market with skill, what’s the point investing in them? Why not plump for cheaper passive investment vehicles and stick with the market return?
Faced with this existential threat, the active fund management industry has naturally come out fighting in defence of the stock picker.
One line of argument focuses on tracking error. Passive investing often doesn’t perfectly replicate an index’s return, not just because of the fees charged but also because of the operational costs and difficulties involved in constantly trying to replicate an ever-changing index. The less liquid the underlying market, the greater the tracking error potential, which is why some bond ETFs have come under particular scrutiny.
Another line of attack is that the best stock pickers come into their own when market conditions are tough.

New Market Conditions

Right now, that’s especially important.
With the Federal Reserve and European Central Bank finally starting to either reverse or slow down some of the measures undertaken in the wake of the global financial crisis, the gentle monetary swell that lifted all boats is set to give way to choppier market conditions. We’ve already seen some evidence of that with the spike in market volatility that sent stock markets tumbling in early February.
This new and unprecedented period of ‘quantitative tightening’ will reward those investors who, rather than follow the crowd, focus on value and company fundamentals, so the argument goes.
This transition offers opportunity, wrote Larry Hatheway, group head of investment solutions and group chief economist at GAM Holding AG in Zurich, shortly after the selloff.
“Once the initial selloff is over, the dispersion of returns should be higher, creating opportunity for skilled active managers. The salad days of benchmark hugging, active or passive, are over,” he said.
It’s a point also made a year earlier by Lisa Shalett, head of investment and portfolio strategies at Morgan Stanley Wealth Management, as the Fed began raising super-low US interest rates.
“Over the last seven years, passive management has benefited from huge tailwinds — low volatility, high correlations, slow growth and reduced fiscal spending — all of which have worked against active management,” she said. “As those things fade, we think it would be foolhardy to abandon active management.”
Whether that heralds a new golden era for active fund managers remains to be seen. What is true, though, is that past performance is no guarantee of future performance; like economists, investors can dwell too much on the rear view mirror than on the road ahead.

When the Going Gets Tough

A white paper by US asset management group Hartford Funds last year highlights a “recency bias” — a tendency to give greater importance to the immediate past than to longer-term trends.
It also shows a cyclical pattern to how well active and passive investing strategies do. Go beyond the liquidity-doped post-global financial crisis era, the Hartford study argues, and the message that comes across loud and clear is that active funds fare better when market conditions are more difficult.
So in 16 of the 22 market corrections seen in the last 30 years, the actively managed funds tracked by Hartford generally outperformed passive funds.
That makes intuitive sense. Clinging to telecoms and technology stocks as the dot-com bubble burst or to banking stocks before and after the Lehman collapse, just because they were a large component of the market index at the time, delivered big losses that would have been avoided if a fund manager had seen the writing on the wall and acted on those concerns earlier by lightening up on those sectors.
There’s a structural argument as well for not overlooking actively managed funds: the passive investment boom of recent years is making active fund managers work harder for their money. A 2015 study by Cremers et al shows actively managed funds becoming more active – i.e. less inclined to hug the benchmark – and also cheaper.
So on balance there isn’t a straight trade off between passive and active investing; there are times when it might make more sense to favour passive strategies, and other times when it would be better to go with a more active style. Or it might make sense to have a mix in your portfolio.
Two things seem clear. Investors need to pick their fund managers carefully – passive as well as active. And after years on the defensive, it’s now time for active fund managers to show what they can do.