While the long-running active versus passive management controversy continues to rage, much of the commentary around the topic ignores what may be the key point of the debate. That is, we should not be debating whether it is possible to add value to investment portfolios through active management, but rather, where it may be possible.
We have found that certain types of risks and decisions historically have a higher likelihood of adding value to investment portfolios through active management than others. Examining aggregate investment returns from active management alone grossly oversimplifies any analysis; even a moderate increase in scrutiny reveals that there are some consistently high value-add strategies, as well as some that don’t deliver. Superficial analysis that aggregates all active returns assumes that all active decision making is equivalent, that all strategies have identical methods and goals. This oversimplification distorts any analytical results, and obscures the true potential for active management to enhance returns.
We believe a more nuanced approach to understanding active management is both appropriate and necessary.
In our view, much of the analysis of the broader active management category has served as a distraction from some of the major issues around the functioning of passive strategies:
Benchmark composition: The composition of the benchmarks used to track investment performance of key asset classes, namely indexes, changes all the time. For example, there have been instances where the performance of just a few large-cap stocks can dominate performance of supposedly broad-based equity indexes. The components of fixed-income indexes can morph quickly based on surges in issuance (borrowing), meaning that index investors will passively lend more to any entity that borrows more, regardless of quality or valuations. Many active strategies will seek to deliver exposure to a different mix of assets than those in the major benchmarks, simply in response to true investor needs (although this difference is not factored in by studies that aggregate active returns). In reality, changes in composition are an issue for all indexes, calling into question just how “representative” a widely followed index really is.
Implementation and fees: Many buyers of passive investment vehicles such as exchange-traded funds just want easy exposure to a particular asset class, in the cheapest way possible, and without a lot of variance from the benchmark (known as tracking error). But a recent review of the two largest high-yield bond ETFs shows that they have struggled to return anything close to the benchmark, while incurring material tracking error. Moreover, this option is hardly “cheap”, as fees tend to resemble many actively managed strategies. We find this issue tends to be common in areas of the market where liquidity is a material consideration.
Concentration risk: Another important consideration is that there can be clear valuation differences between securities that are in or out of an index (think of how the price of a stock jumps upon announcement that it is joining the popular S&P 500 index). By investing in a passive delivery of that benchmark, an investor will own only those securities that are more highly priced, and avoid potentially cheaper but comparable investments. As popular benchmarks become more and more widely held, or aggressively traded by various algorithmic models, passive investors may be joining into crowded trades that are vulnerable to quick reversals. While this may be have short term benefits when everything is going up, and more money piles into these same indexes, investors can be quite vulnerable to market reversals and rapid outflows.