We believe former Managing Director of Barclays Global Investors (BGI), Steven Schoenfeld got it right in 2004 when he recognised that index and active management could – and should – work in tandem.
However, fast forward more than 15 years and it appears that Schoenfeld remains in the minority, with the argument regarding active vs. passive gathering steam as managers on both sides vie to “prove” they are in the right
This argument is naive and largely misses the point. The point should be making a considered decision around what an investor needs and choosing the best available tools to achieve their goals. We believe that investors need help to deliver on their financial goals, not a binary argument on approaches.
Without a robust decision-making framework, investors are likely to find it difficult to make an informed choice.
At its core, the arguments mounted in the active vs. passive debate are often as follows:
Hyperbole aside, both statements have some elements of truth and evidence can be produced to support both. However, in isolation, we believe these arguments are flawed and fail to account for other questions that should be considered. For example:
Often, most of the noise in this debate is generated by those with the most to win or lose, which is not helpful. In order to “win” or “lose” the active/passive debate, everyone would need to have the same objective. Instead, we believe investors should ask themselves several key questions to ascertain whether active or passive management is the best choice for them.
When the individual’s objective is front of mind, the active versus passive debate becomes more nuanced. For example, for an investor with a low tolerance to active risk who seeks to harness market exposure as effectively and efficiently as possible, an active strategy is unlikely to be the solution.
Conversely, for investors seeking excess returns, strategies such as yield enhancement or risk reduction, indexing may also not be an optimal solution.
But what is the solution? And how do we find it?
Much of the problem with the active/passive debate is the binary nature of many of its arguments. Investment management is a nuanced environment, rarely if ever does an issue only have two elements. Creating a series of lenses through which key considerations are viewed helps create a robust decision-making framework. We believe the most prominent of these lenses should be as follows:
Fee sensitivity: A fee budget aids asset allocators in determining how to pursue portfolio objectives. Index-based investing offers an easy way to control costs in a portfolio, however, it is vital to consider cost relative to value rather than consider fees as simply a number.
Market efficiency: Depending on the asset class, markets have varying potential for active managers to outperform due to factors such as liquidity, trading costs, market development and the speed and quality of information dissemination. Some markets may be more conducive to an indexation approach.
Excess return generation: Expectations regarding the level of after fee outperformance generated from a strategy (and the manager’s ability to deliver) is critical. This should involve both an expected range of outcomes, risk taken and likely success rate. While excess return generation in index strategies is expected to be zero or negative after fees, the range of outcomes in Tracking Difference (the difference between the fund return and benchmark return), should be tight. Ultimately, most active strategies need to generate a better overall outcome to be justified.
Conviction in manager selection: Investors need to determine their ability (or ability to access the necessary tools) to adequately identify and monitor managers they believe likely to meet performance objectives after fees. Those unable to leverage quality insights may find tilting to lower-cost index-based solutions more appropriate. This is logical as, after fees, active investing will be a zero-sum game in the absence of manager skill (i.e. for every winner there is an offsetting loser, active investors typically underperform index investors on average after fees).
Risk tolerance: Risk tolerance has multiple aspects, the active risk taken by managers and investors’ tolerance to both active risk and market risk. By their very nature, active management seeks to deviate from a benchmark (Tracking Error) to improve returns. Funds taking low active risk and charging high fees should be avoided. However, even for managers taking high active risk, consistency of results will vary. All managers will experience periods of underperformance as a result of taking active risk to a target benchmark. Investor tolerance to take on active risk in the pursuit of excess returns is integral to achieving success in choosing active management. Likewise, tolerance to taking full market risk in indexation is also necessary. Both active risk and market risk can be emotionally challenging for investors.
Investable index options: Choosing passive investing is only logical where there is a quality investable option. A viable index should accurately reflect the opportunity set within an asset class in a manner that is tax-effective and controlled for biases. In turn, a fund managers replication of that index should balance between tracking error and transaction costs and be appropriately priced. For some asset classes and benchmark unaware strategies, indexation is unlikely to be viable.
Looking at each of these lenses in isolation, outcomes should result in a tilt toward either active or passive investment management as being the more attractive option. This can be viewed as follows:
However, viewing the active vs. passive decision through only a single lens will lead to a skewed result. As many of these lenses are inter-related, a multi-lens approach is likely to provide a much more robust outcome. This is especially relevant given that few of these lenses deliver a definitive answer on their own. Rather, each of these outcomes are likely to sit on a graduated scale. It should also be recognised that there are also a range of other lenses that may be considered, such as tax outcomes.
With multiple lenses on the problem, investors can then bring this issue into greater focus. Once a portfolio’s strategic asset allocation has been set, each sleeve of the portfolio can be viewed using a decision-based framework as follows:
The utilisation of such a framework will fall somewhere between “art” and “science”. Investors can employ different lenses and alter the steps in the process to suit their own needs.
The framework is also somewhat qualitative. By adding quantitative parameters to aspects such as market efficiency, excess returns, tracking error and risk tolerance, scenario testing can bring these issues into even greater clarity and permit greater tailoring.
Given ETFs are increasingly providing access to a multitude of investment exposure, what does this mean for those seeking to build portfolios purely through index-based ETFs?
Again, the answer depends on where you stand. For those seeking an index-based approach to a diversified portfolio, the tools are currently available to build a straightforward portfolio across the different risk brackets using:
Index-based ETFs are available for all the major categories across these exposures. However, for investors seeking a more granular portfolio, some elements are missing.
The following chart highlights all major asset and sub-asset classes and strategies, categorised into whether or not an index-based solution is available in ETFs. What is immediately apparent is that for those who take a positive view on using categories such as microcaps, private credit or equity long/ short strategies, an index-based solution using ETFs (or funds for that matter) is likely to be limiting.
Pure index ETF portfolios are obviously achievable and often at a highly attractive price point for the investor. However, those seeking a more diverse set of return drivers may find that a core-satellite approach to portfolio construction may be most effective. Alternatively, the addition of smart beta ETFs may provide greater choice.
As discussed earlier, the “right” portfolio setting will depend on the individual’s objective. However, some simple ground rules are apparent:
This can be summarised as follows:
Portfolio construction is multi-faceted and should be an iterative process. The essential components to construct the optimal portfolio should be:
The attractions of index-based investing are obvious; generally lower fees, low trading and market impact and removal of the possibility of manager error (active risk). When viewed through this lens, at the individual fund level, index investing is seen by many as a “can’t lose” strategy. However, it is also obviously a “can’t win” strategy if your objective is to beat a benchmark.
We believe that talented active investment managers can outperform broad market benchmarks through leveraging insights in macroeconomics, fundamental research and other informational advantageous. This is particularly true in markets that are less efficient or where no index solutions exist.
However, active management is a difficult task and unlikely to result in consistently positive outcomes in all markets. This is further complicated by investor cognitive biases, which if left unchecked, can result in poor investment discipline when weathering periods of underperformance.
For many investors, a lower-cost approach to achieving market exposure is a tool that should be considered. However, we stress that an indexation approach is rational only if it suits the user’s objective and provides an appropriately priced, highly efficient solution.
Ultimately, investors should view passive products not as an automatic substitute for active management, but as a tool in a more holistic approach to an investment strategy across asset classes and strategies. Investors must ensure they have a robust decision-making process in place to determine which path has the highest likelihood of achieving their investment objectives.
By Dugald Higgins, Head of Real Assets & Listed Strategies.