Passive v Active: A Chief Investment Officers view: Part 1

There are many articles debating the qualities and virtues of passive investing, while at the same time eschewing the benefits of active investing.  Equally, there are a similar number of commentaries voicing the values of using an active approach, while focusing on the detriments of passive investing.

Within our own investment process we look at whether we want to have an active or passive position for a particular asset class.  For active management we are looking for the ability to generate alpha (over a given investment term) where we have our highest conviction.  For passive management the main consideration is will the investment replicate the discrete exposure that we need?

All of these questions have an underlying foundation of having a long term investment horizon as that is where we consider we have a clearer view of where we want to be invested and as such, can have a greater degree of conviction in our investment decisions.

Long term investors are well placed to exploit factors that crystallise slowly, such as demographic trends, emerging market and emerging wealth dynamics and resource degradation.  Over the long term, the return on an asset class is driven by fundamental factors.  Over the shorter term, the return on an asset class is subject to the forces of supply and demand (liquidity, momentum and speculation).  Hence, the shorter term returns from beta are typically volatile.

Rather than a paper debating the merits and demerits of passive and active investing, it seems to me that the underlying foundation is short over long term investing.  Active management lends itself to longer term investing, which as a holistic approach to investing, is what we strive for; strong, longer term investing, withstanding the deflections of short term distractions.

Passive management particularly lends itself to short term investing, as the style is linked to momentum investing, as the bias is towards investing in those stocks that are rising in value, giving passive investing a more growth or momentum tilt.  Many investors use Exchanged Traded Funds (ETFs) to gain short term exposure to Beta in a liquid investment.  When we have short term measurement against market benchmarks, this can end up being counter-productive, as frequent monitoring can contribute to short term investing.  In my view the statistics used to support passive management are a distraction from what is really important: good fund selection based on qualitative, and not just quantitative, judgement.

Within our own PRETTI process we look at returns, but more importantly we look at Team, Talent and Ideology as the bedrock for a fund.  Ideology is about understanding why a fund manager is able to beat the market and much of that answer will come down to process (the ‘P’ in PRETTI), as it is important to understand whether or not the manager consistently maximises market inefficiencies with good processes, avoiding luck and maximising skill.

The most important element is people, as this industry is all about Talent and the Teams in which they work.  If you have the right people with a clear philosophy and a good process, it is likely that performance will come independently of any ‘star’ ratings.

Identification and selection of skilful investment managers is difficult but should be successful over time if based on future return expectations, which, in turn, are based on rigorous application of research into qualitative and quantitative factors.

One interesting outcome of the passive versus active debate, is the symbiotic need for each other; the active manager’s arbitrage role is important in ensuring that stock prices and estimated value are not so far away, and security prices reflect all available information.  In a world without active management, passive investments could increase the boom and bust cycles in stocks through their momentum style.

I take a look at both UK and US markets from an active v passive perspective, in parts 2 and 3 of this series, and then end with my conclusion and summary on this debate. I hope part 1 has proven to be a good “scene setter”

*Equip is the name given to our risk based investment process

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4 thoughts on “Passive v Active: A Chief Investment Officers view: Part 1

  • Hello Shane
    Interesting article.
    How do you go about determining what an asset class is? How do you define an asset class?

    Reply
    • There is no right or wrong way to define and determine asset classes but we define an asset class as a group of securities which have similar characteristics, the four main asset classes being equities, property, bonds and money market instruments. We further analyse the characteristics of the equity securities in terms of geographical location and the development of the economy in which the securities are based. This allows us to have more specific asset classes where appropriate.

      Reply
  • I believe the answer is to use both active and passive.

    Active should definitely be used in the high yield space, buying a basket of fruit knowing that a % of that basket has already started to go off just doesn’t make good investment sense.

    On the flip side, using passive for equity exposure especially in the US where the market is so efficient, fund managers rarely out perform the market consistently. Paying 75 bps for active fund when you can pay 20 bps max,just doesn’t make sense to me.

    I understand Shane’s points re momentum etc but I would argue as most studies would, asset allocation is the driver of investment returns, not stock selection.

    I think a diversified portfolio consisting of both active and passive investments is the perfect storm.

    The problem then comes when choosing how to decide your asset allocation for different risk profiles.

    Bonds are generally considered as lower risk investment, however given the situation we find ourselves at the moment I.e. Interest rates are only set to go one way, bonds are exposed to a very real risk to capital.

    This highlights the importance of being able to adapt your asset allocation inputs according to your risk profile and current market dynamics.

    The asset allocation input is a more key debate than the decision to gain exposure via active or passive vehicles.

    Reply
  • We manage portfolios for our clients and often the debate of active vs passive comes up. The article hits the nail on the head for a number of reasons. One of the arguments for passive is cost, in this brave new world we are so focused on cost that sometimes we assume that cheap is best.

    Taking this further we assume that passive over the long term will outperform active because the costs will narrow the performance margin.

    I would argue that we need to look at this with a different pair of eyes. Cost is important but client outcome is the ultimate goal. We look for good active fund managers who can outperform over the long term. We accept that there are periods when passive will outperform active but we are not here to guess when that will be. So for example in 2011 passives did better and in 2013 in Europe passives were better.

    So we have a long term focus and all studies prove that active will outperform. We are not blind and therefore we have built an index based on passive funds which matches our active portfolios with the argument that if we can’t beat the index then why bother. Over a 3 and five year period we have nearly doubled the index return even with charges with similar volatility.

    We know that the US index is harder to outperform but there are some very good active fund managers who do.

    So my point is that there are times when passive might work but if we focus on what the portfolio is looking to achieve and build from that point then the argument goes because the portfolio focuses on the best ideas to achieve the outcome.

    Reply

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