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“Active vs Passive” Is a False Dichotomy

Published November 20, 2017

So much of the ink spilled on the rise of index investing and exchange traded funds (ETFs) and the imminent demise of active management has been framed as a choice between polar opposites. In our view, both active and index-based investing styles have distinct and complementary roles to play. The real debate today, given our view that beta returns are likely to be muted, should center on how best to combine active and index strategies to create capital-efficient portfolios that can achieve an investor’s objectives.

Index Strategies Gain Market Share, But Still Dwarfed by Active

Without question, index-based strategies have accounted for a growing share of assets under management (AUM), with global ETFs passing the $4 trillion mark in 2017.1 As active managers have struggled to outperform in the current environment and investors have focused increasingly on performance net of fees, we have seen the flows out of active continue. Looking across the global asset management industry since 2011, net inflows into passive strategies were mirrored by net outflows from active strategies in 2016 (see Figure 1). Even so, it is important to put the shift from active to passive into perspective.


While we expect indexing to grow as investors seek efficient access to major markets, index investing accounts for less than 20% of global equities.2 Focusing on the behavior of institutional investors in the largest, most efficient markets in the US, the UK and Japan, where indexing is far more common, can distort the perception of market penetration. On a worldwide basis, active strategies still dominate. Note that in 2017, flows between active managers were 2.5 times higher than flows from active to passive.3

It is also intuitive that the more capital that flows into index-based strategies, the likelier it is that mispricings will arise for skilled active managers to exploit. That, in turn, may attract flows back into active strategies, if they do demonstrate an ability to add value net of fees. In addition, some active and smart beta strategies provide other benefits valued by investors, including higher dividends, lower volatility or more defensive positioning than traditional broad-based benchmarks.

Still, the last few years have been especially difficult for active managers to outperform. As central banks injected liquidity into the financial system to keep interest rates low, the global economy and markets became more interconnected and security returns more correlated, with less dispersion in security level performance that managers could harness through active selection. Lower returns put pressure on active managers to demonstrate value added in line with their higher fees, especially when index-tracking or ETF alternatives could generate similar or better returns at lower cost. Rules-based smart beta strategies have also raised the bar on active managers to demonstrate their comparative advantage after adjusting for systemic tilts toward value or small cap, for example.

Investment Environment Shifting

However, we see evidence that the environment is now shifting in a way that may enable skillful active managers to show their worth. Central banks are beginning to unwind quantitative easing, with the US Federal Reserve leading the way. As interest rates move gradually higher, correlations across asset classes and among US stocks have been on a downward trend this year (see Figure 2).


While dispersion has narrowed somewhat during 2017, market breadth as measured by the ratio of equal weighted to market cap weighted performance has just begun to trend upward (see Figure 3). Overall, we find this investment environment increasingly constructive for active managers, offering them more opportunities to generate alpha. We acknowledge that investors still need confidence they can identify managers with true skill to compensate for higher fees.


Redefining Passive and Active

We would also argue that passive investing is a contradiction.4 Every investor decides how, when and where to allocate capital and that decision is always active — even if the choice is to get beta exposure by investing in a traditional market cap weighted index. Moreover, institutional investors are increasingly using ETFs in very active ways to express their investment views.

And when we talk about active investing today, we are moving beyond the traditional notion of generating alpha by picking stocks based on bottom-up fundamental research.5 Managers who use both fundamental and quantitative tools effectively may have more scope to add value over benchmarks on a risk-adjusted basis, bringing sophisticated and often proprietary methods to bear for uncovering sources of idiosyncratic return. Tactical overlays are also providing new ways to get active within a portfolio.

Finally, factor-based Smart Beta investing is also blurring the lines between active and passive, as investors choose which factor premia to capture systematically through transparent rules-based strategies, with higher return potential than indexing but lower costs relative to active.

Active Not Passive Ownership

Another myth that is important to dispel is the idea that index investing is tantamount to passive ownership. As near-permanent capital, we take our role as long-term investors and fiduciaries seriously. Our asset stewardship practice is aimed at actively engaging with companies in the indexes to help ensure that they are focused on long-term value creation on behalf of our clients. We use both our voice and our vote to focus on good governance practices and companies’ commitment to managing environmental and social issues that can impact sustainable growth.

Preserving Market Efficiency

Some say that the broadly diversified portfolios of index funds are a threat to market efficiency. Yes, the availability of cost-efficient index strategies may draw assets away from unskilled managers who make poorly informed investment decisions. But we would argue that capital markets will always need some level of skilled active management to enable price discovery.

As long as markets are not fully efficient and investor behavior is not completely rational, there will be arbitrage opportunities — however temporary — and active managers to exploit them. By conducting due diligence, identifying a stock’s fair value and investing to take advantage of any mispricing, these active managers help move the market to a new equilibrium price. In short, we believe the invisible hand that makes the equity markets such efficient allocators of capital will continue.

 

1Financial Times, “Record flows for exchange traded funds that track bond markets” by Robin Wigglesworth, October 24, 2017. Figures in USD.
2
BlackRock ViewPoint, “Index Investing Supports Vibrant Capital Markets,” October 2017.
3
Morgan Stanley Research, Oliver Wyman Bluepaper, “The World Turned Upside Down,” March 2017.
4
SPDR Blog, “Investing is Never Passive” by Matthew Bartolini, CFA, September 18, 2017.
5
SPDR Blog, “What Does It Mean to be an Active Investor? The Definition is Changing” by Michael Arone, CFA, September 27, 2017.

 

Definitions

Active investing: An investment approach that involves a manager choosing securities to build, say, a fixed-income portfolio rather than replicating the securities of a fixed-income index.

Alpha: A gauge of risk-adjusted outperformance that measures the excess return of a fund relative to the return of a benchmark.

Index investing: Involves managing a portfolio so that it tracks an index such as the Bloomberg Barclays US Aggregate Bond Index.

Quantitative Easing: A monetary policy program in which a central bank purchases government securities or other securities from the market to lower interest rates and provide financial institutions with capital in an effort to promote increased lending and liquidity.

Russell 2000 Index: An index comprised of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 total market capitalization.

S&P 500 Index: A market value weighted index of 500 stocks that reflects the performance of a large cap universe made up of companies selected by economists; the S&P 500 is one of the common benchmarks for the US stock market, and investment products based on the S&P 500 include index funds and exchange-traded funds.

S&P 500 Equal Weighted Index: An unmanaged equal-weighted version of the S&P 500  Index.

S&P Small Cap 600 Equal Weighted Index: An unmanaged equal-weighted version of the S&P Small Cap 600 Index.

S&P Small Cap 600 Index: A market value weighted index of 600 stocks that roughly reflects the performance of the small cap segment in the US.

Smart Beta: A set of investment strategies that use alternative index construction rules to traditional market-capitalization-based indices. Smart beta strategies seek to capture investment factors or market inefficiencies in a rules-based and transparent way.

Standard Deviation: A measure of dispersion around an average.

 

Definitions

The views expressed in this material are the views of Lori Heinel through the period ended 10/31/2017 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

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