One of the most debated topics in the investment management industry is the active-passive decision. In the fourth-quarter issue of Strategy Insights, we attempt to bridge that so-called “great divide.” We do not view active-passive as an all-or-nothing choice but rather as points along a continuum. Portfolios can benefit from exposure to both, in our view, but in different ways and at different times.
In this article, we explore:
- When do active managers tend to perform best?
- Does active management outperformance work in cycles?
- How do we approach portfolio construction and manager selection?
Our Current Views on Active Management
Active manager performance is cyclical. Our view is that such cyclicality can be used to identify better environments for active managers, or at least understand why certain strategies are doing well or poorly given the prevailing backdrop. Skilled managers do exist, and a thoughtful screening process can help tilt the odds in our favor when identifying them.
A clear understanding of manager exposures will not only help us remain with them during inevitable periods of underperformance but also allow us to carefully combine them within portfolios to maximize risk-adjusted returns.
Even Passive Investing Can Be an Active Decision
It’s important to remember not all indexes are created equal. In some cases, the design of a benchmark can matter more than an active investing choice. Therefore, purchasing an exchange-traded fund (ETF) that tracks an index can also be an active decision. Even when
implementing an asset allocation via passive vehicles, it is necessary to understand the imbedded exposures.This underlines a key point often reserved for active investing; that is, know your exposures and develop an understanding for how those exposures are likely to behave in different markets relative to other choices. Remember, the definition between active and passive is not always as simple as it may seem—how low of a tracking error to a stated index qualifies as passive?
Even the use of passive funds in an active way in a portfolio (having home country bias, for example) should be considered some form of active investing, in our view.
Active or Passive?
A common narrative is certain corners of the market with less analyst coverage and fewer active managers are often less efficiently priced. In general, we believe this to be true, but it is not always the case. As an example, we think active managers often have a better opportunity set in international markets. Simply because international markets are more heterogeneous, active managers can often capitalize on shifting market conditions in different geographies far better than a static passive index. Depending on the objective, however, a passive implementation may also be the preferred course of action:
If we have a particular view on a sector, industry, or region, it is usually most efficient to implement thatvia a passive vehicle. Passive funds that target these exposures are often the cheapest and most direct way to a targeted exposure. Active manager exposures may shift, and regional and sector exposures may simply be an outcome of more company-specific stories within their portfolios.
In certain cases, active manager “alpha” or outperformance may simply be the result of exposure to certain factors that have proven to command a return premium over time. For example, the small-cap premium, value premium, and momentum factor, as captured in the Carhart four-factor model, are thought to be a more accurate way to measure returns. If most of a manager’s returns are explained via certain well-known factors, the manager’s true ability to generate alpha may be limited. Therefore, if simply seeking exposure to a factor that may help increase returns over time, lower-cost ETFs targeting such exposures are available. When choosing active, we hope to acquire exposures outside of these systematic factors that can now be accessed via cheaper alternatives.
Although not applicable for all client types, passive vehicles can be used to maximize tax efficiencies within portfolios. For example, implementing a core equity exposure with a systematic tax-harvesting passive index can be a cost-effective way to gain index exposure while also maximizing after-tax gains. Further, passive funds are often more tax effective
by nature because their turnover is generally far less than the average active manager. That said, we tend to target active managers with below-average turnover.
Simply put, fees matter. Some academics have even suggested fees be measured as a percentage of risk-adjusted returns above the market, not simply as a percent of total returns. In essence, are you getting what you pay for, which in this case is differentiated performance? Although we believe in the value of active investing across asset classes, it may be sensible to favor passive in areas of the market where it has proven more difficult for even top-tier managers to generate significant excess return. However, one again needs to be careful applying this general framework within a given portfolio. A small amount of excess return on a large allocation can add up to a larger benefit in the overall portfolio than better performance in an asset class that has a small allocation. In addition, the costs associated with active equity delivered via separately managed accounts can be quite low, so choosing passive in an asset class that can only be accessed via mutual funds with higher fees might be the right choice even in an asset class, such as emerging market equities, that is otherwise thought to offer stronger opportunities for active managers.
What Is the Right Mix?
Ultimately, there is no one-size-fits-all approach to bridge the great divide between an active/passive mix.
We laid out the key issues we consider in evaluating portfolios. It depends on the composition of the overall portfolio, the market environment, and the preferences of each investor. We believe the peak in passive investing may be behind us, and as the investment landscape evolves we expect a return to active management.