The long-running active-passive fund management debate will never be solved if its either/or framing, which incorrectly treats the two approaches as mutually exclusive, isn't revised.
The debate has also become skewed owing to the tendency to narrowly focus on cost rather than net value added. In this edition we revisit the pros and cons of each approach, with the notable inclusion of how each seeks to incorporate increasingly important environmental, social and governance risk factors into its methodology and examine why this further skews the debate.
The misframing of the active-passive decision
First up, the active versus passive fund management debate, with its either/or framing, incorrectly treats the two approaches to managing money as mutually exclusive - which they aren't. Indeed, the appropriate active-passive mix for any investor - and it will often be a mix - depends on: the investor's investment beliefs - particularly how markets function, the degree to which the asset classes in focus are efficiently priced1 and the value of diversification; their investment goals; their investment governance budget2; their risk appetite; and how they frame risk.3 Indeed, most investors will approach the active-passive decision on an asset class by asset class basis and construct portfolios that comprise both actively and passively managed asset classes.
Next up is the tendency to approach the decision problem through a narrow cost, rather than a wider net value added, lens. Doing so has again resulted in a skewing of the debate, with many investors taking the line of least resistance and opting for a low-cost passive, or index tracking, solution. Rather, a focus on the ability to sustainably generate net value added - that is, delivering sustained superior risk-adjusted performance after fees while meeting desired investment outcomes and risk appetites - is how the active-passive decision should be approached.
So, with those two elephants given their marching orders, let's take a step back and evaluate the pros and cons of passive and active approaches to fund management, and then a step forward by bringing into the debate the incorporation of increasingly central environmental, social and governance (ESG) risk factor considerations. As equity fund management has been the principal focus of the debate and generated the most research, let's start with managing equities on a passive basis before moving onto active equity management.4
Passive fund management
Passive management, or index tracking, involves constructing a portfolio of securities that replicates or tracks the total return of an equity index, on the premise that securities are efficiently priced. On the plus side, index tracking minimises the risk of underperforming the benchmark index before fees and the costs of investing by only transacting when necessary, such as when new money and investment income is received, to meet investor redemptions and accommodate periodic changes to the index being tracked. On the flip side, however, once fees, costs and a number of minor technical factors are taken into account, underperformance of the market often results. Moreover, being fully invested in the chosen index means trackers follow the market down as well as up.
Most equity index tracker funds are based on market capitalisation-weighted indices, such as the S&P 500 and FTSE All Share, where the largest stocks in the index by market value have the biggest influence on the index's value. However, tracking market cap-weighted indices is not without its problems. Index trackers cannot be customised to meet all investor objectives and risk appetites -the index chosen is the index tracked. As we'll see, this can be particularly problematic for investors seeking to integrate ESG risk factors into their portfolios. Also, diversification is often compromised by the index being highly concentrated in a few sectors - although the opposite extreme, overdiversification, is true when tracking more broadly based indices.
Far and away the biggest problem though, is that the largest positions in the index are concentrated in those sectors and stocks that the market perceives to be the most successful, even though these may transpire to be yesterday's winners rather than today's. Indeed, with rapid product innovation and lower barriers to entry for potential new entrants in many industries, industry pre-eminence can often be a temporary phenomenon. Moreover, the resultant misallocation of capital and subsequent drag on performance is particularly acute in momentum-driven equity bull markets. This is because market cap-weighted index trackers are forced to allocate more money to what prove to be increasingly overpriced market favourites and less to those sectors and stocks likely to be undervalued.
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1The idea of efficient markets dates back to the pioneering work of Alfred Cowes in the 1930s, Harry Roberts and Harry Markowitz in the 1950s, and Bill Sharpe and Eugene Fama through the 1960s and 1970s and is encapsulated in the efficient markets hypothesis (EMH). The EMH states that market prices continually reflect all available and relevant information. They therefore move randomly and independently of past prices as investors react rationally and instantaneously to new market news. While the EMH acknowledges that market participants do make random mistakes, it assumes people learn from their mistakes and do not repeat them. Crucially, these random errors are presumed to offset one another. Even if not offset, the contention is that transactions costs would render the opportunity unprofitable. If correct, and it is a big if, the EMH has obvious, damning implications for those investors seeking to outperform the market. After all, if market prices continually reflect everything known or knowable about the market's constituent securities, then investors cannot hope to consistently beat the market unless they are very lucky or are prepared to take higher risks, which may or may not be rewarded.
2The finite investment governance budget of any decision-making board or committee is commensurate with its collective capabilities, its specialist investment knowledge, the efficacy of its time management and how well it organises itself.
3Risk means different things to different people. After all, risk, being multi-faceted, isn't fully captured by any one number. In the context of manager benchmark risk, also known as active risk or tracking error, whereas there is little risk of an index tracking manager deviating significantly from their chosen benchmark index, the same isn't true of many active managers, especially when the conditions are right to fully utilise their active risk budget. Indeed, the higher the active manager's tracking error, the greater the potential for both significant outperformance and underperformance.
4For a more detailed technical overview of active and passive fund management, please see: Brave new world: Why active managers are well placed to take advantage of social, economic and political regime change. Chris Wagstaff. Columbia Threadneedle Investments. February 2017.
This post is funded by Columbia Threadneedle Investments