Myth-buster series: Active v passive is a binary choice?

by , 28th November 2017

The way investors like decisions to be framed as either/or questions Is natural given what is often at stake. At a basic level, investing itself is a decision to either invest or to not invest and even market sophisticates are drawn to the simple analogy of markets being either risk on or risk off.

No prizes then for guessing that the debate regarding active and passive management is often cast as a binary choice. A simple question of yes or no. Yet like many other apparently simple decisions, this over-simplifies a more complex picture.

“Differentiating between active and index strategies is often a useful shorthand,” say the capital markets team BlackRock in their market viewpoint from October. “However, whereas much of the current dialogue pitches active and index investment strategies against each other as opposites, the investment landscape is in practice more nuanced.”

The BlackRock team make the point that the investment landscape is better understood as a continuum of investment styles where absolute definitions are increasingly blurred. Specifically, the chosen investment style will be delivered via a set of products which will be driven to a greater or lesser degree by either active or index management and with a proportionately greater or lesser relationship to the index.

BlackRock go on to define the four common investment styles; active- absolute return, active relative return, active and index factor strategies and finally purely index strategies. As BlackRock point out, the first of these categories is effectively dominated by hedge funds which employ investment techniques that generally are not available in traditional asset management products, such as short selling, use of borrowed funds, more sophisticated financial contracts, or physical positions in commodities. They also, not coincidentally, charge the highest fees.

Welcome to ETF-land

In the last three investment styles we see ETFs in one form or another enter the equation. Fully active ETFs clearly fall into the active, relative return category. But this is also the area where, according to active management’s critics, we would find the index-hugging funds, charging an active premium for an effectively passive return.

Then we get the factor strategies and the world of smart beta. The latter might be a new term, but as BlackRock point out, investing in size and style factors has a long history going all the way back to the 1930s and Benjamin Graham. Smart beta formalises many of these factors into some key strategies such as value, volatility, momentum, dividend yield, and/or size.

“In this way, smart beta incorporates elements of both active and index: the benchmark is the result of an active process and the resulting portfolio replicates or tracks the benchmark,” say the BlackRock team. “Factor strategies have generated increased interest as investors try to implement investment exposures that target risk and return profiles that differ from traditional market capitalization indexes.”

Then we finally get to ‘pure’ passive index funds. Yet, as BlackRock point out, using the term index strategies “may give the false impression of a fully automated approach to investment management.”

“These strategies do seek to track the composition and performance of an index closely, but require specialist portfolio management expertise to do so,” they say. There are three characteristics that index provider and index funds will generally look to in order to construct and track benchmarks.

  • Transparent – meaning that the rules of the index, its risk-return profile and the constituents are disclosed
  • Investable – meaning that a material amount of capital can be invested in the index constituents and the index’s published return can be tracked
  • Strictly rules-based – meaning that no portfolio manager intervenes in determining the investment universe and holdings of the fund (away from managing the minimization of tracking error, transaction costs or other restrictions). The portfolio management process for index investments does not rely on fundamental analysis of individual stocks and maintains economies of scale that tend to facilitate lower expense ratios

The development of indexes

A vital ingredient in all this is the index themselves. As BlackRock say, they have become indispensable parts of the capital markets and investment process and are used for myriad purposes: tracking the performance of markets or sectors; measuring portfolio manager skill versus a benchmark; as building blocks for portfolios; and, as key inputs to stock price discovery in global markets.

The growth of index investing has, then, “catalysed” new questions about index investing and the ownership of company stock, and renewed those questions posed in the early years of index markets regarding the impact of index investing on efficient price formation for stocks.

But it also make plan that the issue of active versus passive is now, more than ever, not an either/or. To coin a phrase, it’s more complicated than that.

ETF Issuers Featured in this Article