Exploring the ongoing debate between active and passive investing
21 January 2020
As the trend for passive investing is showing no signs of abating, Zehrid Osmani, Head of Global Long-Term Unconstrained explores the place for active management and the opportunity it can bring for asset allocators.
Active versus passive
With the advent of passive investing in the past two or three decades, the detriment to active investing has been very pronounced. Equity investors have been lured by the attraction of lower fees that passive investing offers, but also driven to seek an alternative to the disappointing outcomes that active investing as a whole has offered. This is illustrated in the chart at the end of this section.
Passive investing is effectively able to deliver on its promise to investors to keep up with market returns, something that active investing has failed to do in some markets and over certain periods of time. Active investing has had periods of outperformance, which has supported the case for its cause, but has also had periods of underperformance, which has led to more support for passive investing. Indeed, part of the confusion in the debate between active and passive investing is varied evidence of active investing performance, whose conclusions are dependent on both markets that have been studied and periods analysed.
Yet, despite the fact that this trend towards passive investing is likely to continue, we believe that active investing will still have a role to play in asset allocators’ portfolios. We also believe that some active investors genuinely have skill in generating good returns. The critical aspect for asset allocators is to spend more time assessing active investors for the real skills that they bring to their portfolios using structured frameworks to identify these genuinely skilled active investors.
Furthermore, the advent of big data analytics can provide another support for active investing over passive. Large and growing quantities of available data are pushing active investors to innovate in that field through the use of data scientists, but this can have the opposite effect of pushing investors to be even more reactive in how they manage investments. By contrast, we believe that adopting a longer-term time horizon, and a focus on predicting long-term trends can be the key edge that active managers provide for investors. In other words, an ability to identify undervalued investment opportunities over the long term is active investing’s strongest value-add.
Passive as % of total across regions - equity only
Source: Goldman Sachs ‘Are passive funds taking over Europe?’ and Morningstar.
We believe that adopting a longer-term time horizon, and a focus on predicting long-term trends can be the key edge that active managers provide for investors. In other words, an ability to identify undervalued investment opportunities over the long term is active investing’s strongest value-add.
The importance of being differentiated in active investing
Another important differentiator that active investing can achieve is to be very different to the index. Therefore, finding investors with a high active share (which measures how different a fund is to the index it operates in) is a way to ensure asset allocators identify such active investors (and therefore avoid so-called closet tracker investors).
In addition, systematic behavioural biases in markets makes another case for active investing over passive, although this requires that active investors are conscious of the behavioural biases that exist, and are able to benefit from them.
Furthermore, there are markets where concentration of the index is high (such as some emerging markets), and therefore diversification of the index in question is low – this points towards an increased risk for passive investing in terms of lack of adequate diversification, something that active investing is able to address in a more thoughtful manner.
Finally, active investing will have an important role to play for asset allocators that want exposure to purpose investing, a trend that will likely be growing considerably over the years to come. Linked to this, the growing demands for investors to be actively engaged also provides strong support for active investing in the future.
And to finish, a thought that I feel is conceptually defendable but needs exploring in more detail: as passive investing continues to increase and becomes a dominant part of the overall market, it could lead to less efficient markets, and therefore could open up more opportunities for active investors to outperform.
The active versus passive debate
We believe that there are a few things worth highlighting in the debate between active and passive investing, which we do through the headlines below:
- Passive investing is in itself an active investment decision – it is the decision to allocate a portion of one’s investments towards an instrument that will simply aim to keep up with the index return, for a low fee.
- A negative perception on the ability of active managers to deliver positive returns – the perception that active investment has provided disappointing outcomes for investors can perhaps be explained by the timeframes involved. While there have been various studies, citing underperformance of active managers, equally there are numerous examples of genuine long-term active investors outperforming markets and passive strategies over the long term.
- A commitment to active investing requires that investors believe in markets being inefficient – bubbles, booms and busts do in many ways highlight that markets are inefficient and overshoot on the upside and on the downside, with investor sentiment (and therefore behavioural bias) playing an important role in this. Robert Shiller (1981)1 makes a good argument for how markets are not efficient, given that share prices are more volatile than the cash flows and dividends of the underlying companies.
- Behavioural biases in the market provide one of the strongest arguments for active investing – a lot of literature has developed over the past 10 years focusing on behavioural analysis and investors’ systematic biases, which highlights the fact that markets are prone to biases, and are therefore inefficient, which opens up opportunities for active investing. Kahneman and Tversky (1979) highlight in a study (Prospect Theory: an analysis of decision under risk) that individuals are systematically irrational and make predictable and repeatable mistakes, which points to persistent behavioural biases.2
- Purpose investing and active ownership provide strong support for active investing – a growing trend towards more purpose in investing points to investors not solely assessing investments based on risk-returns. A demand by some investors for more active engagement with companies, to improve both governance and sustainability, helps the case for active investing given that managers are best placed to carry out the active engagement in our view.
- Asset allocators should focus on finding active investors with genuine skills – there is evidence of some active investors generating good returns over prolonged periods. There is a need to assess active investors’ pure alpha skill; that is, their ability to genuinely pick the right stocks and outperform the market, rather than benefit from some supportive factor(s) that they have exposure to. Asset allocators should also assess how genuinely active their active managers are; for instance, how different their exposures are compared with the index they are aiming to outperform. A high active share is a way to assess such aspect.
- Passive investing also has its inefficiencies – passive investing gives investors a low-cost exposure to a chosen index. While it has its benefits in terms of cost and liquidity, it exposes investors to all parts of the market, including those that are less attractive. It can also, in some instances, lead to low diversification, if gaining exposure to indices that are highly concentrated on a few stocks – something that active investors can manage more efficiently.
- Smart beta investing is a further challenge for active management – smart beta is not a new development, although its application in terms of new low-cost product offerings for investors is a further disruption for active investing. In a way, the only smart thing about smart beta is its name. The concept of disaggregating the components of beta into its factors and offering low-cost ways for investors to gain exposure to these components is a simple one and has been around for decades. Factor exposures are easier to gain as a result of smart beta investing, which means that it is even more critical for active investing to focus on pure alpha generation.
Asset allocators should focus on finding active investors with genuine skills – there is evidence of some active investors generating good returns over prolonged periods.
The challenges for active management
Overall, as we mentioned at the start, active investing will continue to have a role to play in asset allocators’ portfolios in our view. However, active investing has its own challenges in terms of how it approaches its search for alpha. Below, we highlight some challenges and suggestions that active investors need to reflect on.
The advent of passive investing has been fuelled by underperformance of active investing
The trend towards more passive investing, as evidence of a lack of skill in active management, has been mounting over the past decades. Investors have been making the decision to go passive to ensure that their returns keep up with the market returns. Low fees for passive investing have further helped to make the case for passive investing. The other argument for passive investing is the ability to rapidly gain exposure to a market at a low cost, something that asset allocators will always value.
Active investors underperform on average
Many commentators highlight that the market is a zerosum game. Studies have shown that on average, active investors tend to generate returns in line with the market before fees. This is damning for the case for active investing, given that it means that active investors underperform after fees.
A paper by William F. Sharpe, ‘The arithmetic of active management’3 published in 1991 makes some interesting and simple arguments that we think capture the zerosum game comments about financial markets that we often hear.
Finally, it is worth highlighting the outcome of these studies can be dependent on both the time period and the market analysed. In an efficient market such as the US, active managers have historically struggled to outperform, whereas within less-efficient global markets there appears to be more opportunities for active managers to deliver alpha to investors.
The case against passive investing is the lack of ambition
Clearly, the decision of asset allocators to go passive is in itself an active decision; asset allocators have actively decided that the active investors they have in front of them are unable to generate positive excess returns. Asset allocators have therefore made the active decision that they will invest in a way that their returns will end up being broadly in line with the market return (depending on how close to the index and how efficient their passive instrument of choice is). While this doesn’t sound like an ambitious target, the repeated disappointments that active investment returns have given them is a key argument for this.
Passive investing can also carry diversification risks
As we have highlighted in the past, passive investing carries some risks related to diversification. Some indices have high concentration (notably in emerging markets), which leads to passive investing not achieving the right degree of diversification that asset allocators would want to achieve. In these instances, active investing can provide a more thoughtful approach in achieving diversification in such markets. Also, some indices have over-representation to state-owned enterprises (SOEs) – SOEs are not always managed for optimal value-creation, so passive investing can lead to sub-optimal exposure to areas of the market that might not generate the value-creation that asset allocators require.
Within less-efficient global markets there appears to be more opportunities for active managers to deliver alpha to investors.
Asset allocators need to use a framework that identifies skilled active investors
In the debate between passive and active investing, it is important to note that some investors genuinely have good and consistent long-term track records of outperforming the market. Asset allocators should have a framework that helps them identify these skilled active investors. Measuring skilled investors should be done based on their ability to generate pure alpha. Pure alpha is the excess return that investors can generate over and above any factors that have contributed to the excess return (such as market cap, style, sector, country).
Assessing an active investor’s ability to generate returns on a risk-adjusted basis is also important. Therefore, measuring an active investor’s information ratio and Sharpe ratio are additional ways to ensure that asset allocators can judge the proper skill-level of an investor more accurately.
Measuring how much an active investor deviates from the index is also a good way to assess how active an investor genuinely is, which is what the active share ratio does. Asset allocators should therefore take the active share into account when assessing active investors. There is evidence of higher returns generated by investors that have a higher active share. In their paper ‘How Active is Your Fund Manager? A New Measure that Predicts Performance’, Cremers and Petajisto4, examining 2,650 funds from 1980 to 2003, found the highest-ranking active funds (those with an active share of 80% or higher) beat their benchmark indexes by 2–2.71% before fees and by 1.49–1.59% after fees.
Behavioural analysis of investors should also play a role in assessing genuinely skilled active investors – as opposed to merely lucky ones. Behavioural biases will dictate the approach an active investor takes; it therefore is important for asset allocators to have a clear understanding of the behavioural biases that their active investors emanate.
Team structure and the culture of a portfolio management team are also important areas for asset allocators to assess when choosing portfolio managers. This is because both factors play a big role in determining not only the ability to generate alpha, but importantly, maintaining the consistency of alpha.
Finally, there is perhaps one element above all others that asset allocators should look to identify in their framework for assessing and identifying skilled portfolio managers. It is, in my mind, the most important ingredient I look for in analysts and portfolio managers and is simply characterised as passion: passion to run investments; passion to generate the alpha that is expected of a portfolio manager; and passion to deliver the right outcome to clients. All of these are intertwined, and all of them require a big dose of passion indeed. It is certainly a subjective assessment, but is a vitally important one to ensure that asset allocators pick portfolio managers and teams that have the thirst to deliver for them the right outcome, no matter what the market throws at them.
Adding value through active management
Short-term focus detracts active investors from performing
The increasingly short-term focus of the markets, what we call market myopia, is leading investors to focus on shorter-term outcomes, which in our view reduces the ability of active investors to outperform for sustained periods of time. The average holding period has reduced dramatically since the 1960s, which illustrates well the very short-term focus of the market.
NYSE average holding periods, 1929 - 2016
Source: Redrawn from an original chart produced by Ned Davis Research, December 2016.
We believe that the market myopia does open up some good opportunities for investors that have long-term time horizons, which therefore makes a strong case for active investing, providing it is done with a long-term timeframe. Long-term investors have the opportunity to benefit from inefficiencies in the market created by the excessive focus on short-term investing.
‘Nowcasting’ is further exacerbating the short-term nature of the markets
With the advent of big data, investors have been under pressure to show that they are able to harness the vast amount of data available in more sophisticated ways. A lot of active investors have been increasingly working on capturing this unstructured data for their analytical purposes. However, it is worth highlighting that a large part of the data that is available is only helpful to paint a picture of what is happening now. Therefore, investors have increasingly focused on ‘Nowcasting’ current trends rather than forecasting long-term trends. This has pushed the market towards acting on short-term signals and focusing on finding opportunities that are short duration, rather than spending time to reflect on long-term trends and finding appropriate long-term investment opportunities.
The tendency for big data to push investors towards shorter-term time horizons is what has led us to say on many occasions that big data is an accident waiting to happen and in our view, can be misleading to investors.
Smart data is vastly superior to big data
Long-term forecasting of trends is critical for successful active management. Successful active investors should focus on developing their ability to forecast long-term trends in industries and companies, in order to help them capture the right long-term investment opportunities and to help them increase the likelihood of outperforming the index. Smart data analytics, focusing on fundamentally derived data, rather than shorter-term, big data analytics, should help investors pick the right opportunities.
Active investors confuse being proactive with being reactive
Many active investors have a tendency to act on shortterm signals, which is perhaps borne from a belief (subconscious or otherwise) that a certain level of portfolio action adds value for clients. Yet we find that this is in reality confusing being reactive with being proactive. Some of these investors tend to react to newsflow in a short-term manner, rather than spending time focusing on the long-term picture that is ahead of them, and assessing whether that long-term picture has changed in any material way from any newsflow that comes out.
High turnover impacts returns negatively
Being reactive and short term tends to lead to increased portfolio turnover. Increased portfolio turnover tends to impact returns detrimentally, not least because of the higher trading costs incurred by the ultimate investors in such strategies. This calls for active investing to focus more on buy-and-hold strategies; for example, long-term investing, with low turnover, to reduce the trading costs related to turnover.
The tendency for big data to push investors towards shorter-term time horizons is what has led us to say on many occasions that big data is an accident waiting to happen and in our view, can be misleading to investors.
Active investors should increasingly focus more on long-term trends
We find that the market tends to underestimate compounding characteristics of companies generating high returns and high cash flows in the long term. This is because of the short-term focus of the market. I have come across investors who have argued that it is easier to be accurate about a company’s earnings in the near term than in the longer term. Longer-term forecasts have a higher magnitude of forecast error. While this might be true, what these investors are missing is that being more accurate about shorter-term earnings predictions doesn’t guarantee the ability to call short-term share price direction correctly. There are many more factors influencing share prices, of which expectations of what is in the share price and investor positioning in a stock are both important determinants. This makes shorter-term predictions of share price moves difficult and unreliable in our view.
We believe that active investors would increase their potential to generate excess returns if they focus more on forecasting accurately long-term industry trends and company cash flows and returns. Spending time analysing industry dynamics, growth prospects, companies’ competitive advantages and ramparts to defend themselves from competition, predicting innovation and disruption trends, all help to find the right investment opportunities in the long term. Active investors should focus on developing and improving their long-term forecasting skills to be able to make a strong case for active investing.
Behavioural biases point to markets being inefficient
Behavioural analysis has been an important area of development in the past two decades, showing that investors have biases, which are often subconscious. In ‘Prospect Theory: an analysis of decision under risk’, Kahneman and Tversky (1979)5 highlight that individuals are systematically irrational and make predictable and repeatable mistakes. Markets overshooting or undershooting, booms and busts, greed and fear, risk aversion and overconfidence are all traits that investors have shown on many occasions and point to markets being impacted by investor psychology and therefore behavioural biases. This makes these biases repeatable, creating inefficiencies in the market which active investing can benefit from. But for this to be the case, active investors have to be aware of the markets’ and their own behavioural biases; only then, will they be able to more systematically benefit from such inefficiencies.
Purpose investing and active ownership are likely to be supportive of active investing
Investors have been increasingly shifting towards purpose investing, a trend that is likely to continue, and even accelerate over the years to come. Purpose investing dictates a more targeted approach towards investing, by requiring identification of companies that fit the outlined purpose of the investment. This requires an active approach to investing in this field. This will be even more important as purpose investing increasingly requires an active engagement with the aim to achieve beneficial change in the way companies behave. Active engagement, by definition, requires active investing, given that passive investing is unable to provide that to investors. This growing trend will therefore provide some support for active investing.
We find that the market tends to underestimate compounding characteristics of companies generating high returns and high cash flows in the long term. This is because of the short-term focus of the market.
There is room for both active and passive investing to co-exist.
The debate between active and passive investing will remain intense and prone to conflicting evidence along the way. While passive investing provides some benefits to investors, in terms of cost and liquidity, it also has its shortfalls. Passive investing lacks an ambitious target on returns potential, given that it will just keep up with the index return. It can also lack diversification, and importantly exposes investors to all areas of the market, including the unproductive parts (which we define as parts of the market that will fail to generate value or that will destroy value for investors).
Active investing also has its challenges, the main one being a lack of evidence that it can generate the right returns outcome for investors. Active investing should rethink its approach to finding attractive investment opportunities, should reconsider the time horizon it invests in, and move towards a longer-term, less index-constrained way of investing in order to increase its chances to perform. Asset allocators should have a structured systematic framework for assessing active investors with genuine skill in generating positive returns. Active investing will likely benefit from the growing trend towards purpose investing. Active investing is also able to deliver the active engagement and ownership that some asset allocators require. Finally, as passive investing continues to increase, and as it becomes a bigger part of the market, it could lead to less-efficient markets, which in our view will increase the ability for active investing to generate superior returns.
As passive investing continues to increase, and as it becomes a bigger part of the market, it could lead to less-efficient markets, which in our view will increase the ability for active investing to generate superior returns.
1Shiller, R (1981) Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends, American Economic Review, 1981, vol. 71, issue 3, 421–36.
2Kahneman, D. and Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, Vol. 47, No. 2 (Mar., 1979), pp. 263-291.
3Sharpe, William F., (1991), The Arithmetic of Active Management, Financial Analysts Journal. Jan-Feb 1991.
4Cremers, K. J. Martijn and Petajisto, Antti, (March 31, 2009). How Active is Your Fund Manager? A New Measure That Predicts Performance AFA 2007 Chicago Meetings Paper; EFA 2007 Ljubljana Meetings Paper; Yale ICF Working Paper No. 06–14.
5Kahneman, D and Tversky, A (1979) Prospect Theory: An Analysis of Decision under Risk, Econometrica, Vol. 47, No. 2 (Mar., 1979), pp. 263–292.
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