Active? Passive? Just remember the real objective

The debate surrounding active versus passive investing has raged on for over four decades, yet remains unresolved. This is because the focus has been on a binary conclusion—absolute active or absolute passive. In this article, we discuss the key points in the debate—but more importantly, we offer some thinking as to when both active and passive investing can be used, and how they can be combined to form an effective investment strategy.

What is active versus passive investing?

As the name suggests, a passive investor is one who is relatively ‘hands-off’ when it comes to security selection. The investor will typically try to replicate a market exposure by purchasing an index fund or an exchange traded fund (ETF) which tracks a market index, such as the S&P/ASX 200.

In contrast, active investing is solely focused on outperforming a specific benchmark. It takes a ‘hands-on’ approach to security selection and/or market timing. Outperforming the market involves a deeper level of analysis, specific expertise or structural advantage, and these funds therefore generally attract a higher fee than index funds.

Remember the real objective

This question is often overlooked in the debate—but it’s an important one as we need to know if investment objectives are being met, and whether they’re being met in the most efficient way. The typical investment objective of many investors is not specifically to outperform a benchmark, but to focus on one or a combination of the following:

·         An ‘inflation plus’ targeted return;

·         limited capital loss over the investment cycle;

·         specific cash flow requirements; or

·         reduced volatility.

Passive investing is a zero-sum game…

The market represents the average of millions of buyers and sellers, implying that roughly 50% will outperform the benchmark and 50% will underperform. This is a key argument among index fund providers, with the rationale being that it’s incredibly difficult to know which active managers will outperform a stated benchmark. Therefore, the most rational solution is to buy an index fund.

…but many benchmarks are inefficient

What many index fund providers neglect to tell us is that many indices are structurally inefficient, and they don’t represent thoughtfully-constructed portfolios. For example, if you benchmark to the S&P/ASX 200 index, you would be allocating around 35% to financials. If you benchmark to the UK FTSE 100 index, you would be allocating around 15% to energy stocks, which are heavily impacted by the price of oil. Just because these are the largest companies in their respective indices doesn’t mean you should be taking such major sector concentration risk. However, this is not a criticism of just passive index funds, but also of active managers that closely track benchmark indices.

You need to pick the right active manager

If you are going to pursue an active investment approach, you need to be highly confident that the manager(s) you have chosen will be one of the ‘winners’. This is obviously difficult and requires extensive due diligence and an understanding of the competitive or structural advantages that will add ‘alpha’.

Some asset classes are difficult to passively replicate

Alternative investments, such as hedge funds, were originally designed to be benchmark unaware, and to perform well, irrespective of market conditions. While their purity to this cause has declined over the years, and benchmarking has infiltrated the sector, it remains incredibly difficult to replicate these strategies via a passive fund or ETF.

Using the best of each strategy

From the above, it should be clear that to get the most out of our capital, we need to use the best of each strategy. Here are four easy ways to implement investment strategies with active and passive investing in mind:

1.    Passive investing is not well suited to fixed income and alternatives

Fixed income indices are broadly inefficient due to opaque pricing and the illiquidity that characterises bond markets. By allocating according to issuance, it means you are allocating more portfolio assets to the most indebted issuers—this makes little sense. Likewise, the alternatives sector is too broad to benchmark, and the strategies of the most successful managers are impossible to replicate given their idiosyncratic nature.

2.    Favour passive equity exposure when valuations are expanding

Passive investing can be advantageous when markets are undergoing price to earnings (P/E) expansion. In this kind of market, when a rising tide lifts all boats, why try to pick the winners when you can simply ride the market higher by buying the index? Additionally, passive index funds do not have the cash drag that active managers do—so you have more exposure to the rising market.

3.    Favour active equity exposure when earnings are the driver

Markets in which P/Es are expected to remain stable, or even fall, are best suited to active management. This is the market we currently find ourselves in and, in this environment, it’s best to limit broad market or ‘beta’ exposure and focus on companies that will likely be rewarded for earnings growth.

4.    Use ETFs for thematic exposure

ETFs offer an excellent way to gain exposure to specific investment themes or markets, which are hard to access. For example, if you believe that the environment is fertile for oil refiners, gold, Indian small caps or solar energy, then the easiest and most efficient implementation is likely to be via an ETF.

In conclusion

At Crestone, we see a place for both active and passive investment vehicles in a well-constructed globally diversified portfolio. If you are considering a passive investment vehicle, be cognisant of the efficiency of the index and what stage of the investment cycle we are in. If choosing an active approach, ensure that the manager has sustainable ‘alpha’, which pays them for the idiosyncratic risk and conviction they are taking.

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