Active vs. passive

November 23, 2015 08:00 AM

The argument between active vs. passive management is widely thought to be over, with passive investing declared the winner. This has occurred over a multi-decade bull market that has been disrupted by three major market events. 

In fact, the assumption that passive stock investments—with their lower fees and ability to track the major stock indexes—are a superior investment has been so accepted that is has spread to other assets classes and strategies. Long-only passive commodity funds became the rage a little over a decade ago when fear of inflation began to grow. Commodities have long been seen as a hedge against inflation and a passive investment into commodities because they were much more palatable to the retail investment community than the idea of trading those “risky and volatile” commodity futures markets. 

Its ascendency in the 2000s was credited to the financial engineering work in the long-biased equity world that declared passive investment strategies superior to mere stock-pickers. 

Even in the world of alternatives, strategy innovators began to come up with the concept that passive benchmarks could be created to replicate the value of certain strategies. There are now trend-following indexes and exchange-traded funds that promise to deliver the goods with lower fees. Of course, it is a large leap to go from a passive index hoping to replicate the returns of the S&P 500 than it is to replicate a more complex strategy like trend following. 

The reliance and advocacy of passive investing in the stock market corresponded with arguably the longest bull market in history. So not only does research show that, on average, a passive investment outperforms active stock-pickers at a cheaper cost, but the passive strategy providing index-based returns has produced solid returns over long periods. 

Why bother sifting through wheat from chaff of active managers in the hope of finding the few who outperform their benchmarks? Better just to put you money in an index fund. But what happens if we enter a prolonged bear or flat market environment. It took five years and five months for the Dow Jones Industrial Average to take out its 2007 high after the bursting of the housing bubble led to a global downturn. The rally that proceeded it has been one of the strongest on record. It took more than six years to make a new high after the market topped in 2000. But from the beginning of 1973 to the end of 1982 the market provided no return. History tells us that we will have one of those periods again. 

In our cover story “Active vs. Passive: The turf war continues,” (page 16) we cover all aspects of the active vs. passive debate. Thomas Howard presents an updated argument for the value of active investors. 

If we return to an extremely quiet market that persists for a decade, it would be hard to rely on a passive investment strategy—and perhaps easier for active managers to distinguish themselves in a world where it no longer pays to simply show up. If a rising tide lifts all boats, a stable tide will require more skill. 

Morningstar’s John Rekenthaler points out in “Identifying active stars,” (page 22) that strong performance from active managers is often tied to strong performance in small cap stocks. Rekenthaler acknowledges the reality of the performance statistics that show passive funds outperforming active managers, but says it is possible for active managers to outperform their benchmarks over an extended period. The key, of course, is fees. The smaller the fee, the smaller the hurdle an active manager has to overcome to beat a cheaper index fund’s performance on a net basis. 

But what we are learning, especially with the onset of robo-advisors and smart beta strategies, is that active vs. passive is not an all-or-nothing game. There are various investments that will fall at numerous spots along active/passive scales (see “How active is your active manager,” page 25). 

Some active investment advocates say that a new, better, environment for active investing may emerge when interest rates finally begin to rise. They could be right but a lot of folks have grown weary waiting for that to happen. 

One thing is certain. If we fall into an extended period of flat to negative returns in equities, hitting your benchmark will not be a desirable thing so you may want to find a manager who is capable of outperforming the market. And, of course, allocate to alternative that can produce positive returns in poor equity markets. 

 

 

Daniel P. Collins
Editor-in-Chief, Modern Trader
@moderntradered

About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.